Overview
There is a common misconception that the Federal Reserve (Fed) controls mortgage rates. Why is this belief false? In short, the Fed only directly controls interest rates for short-term loans, while mortgage rates better align with longer-term rates. Some think short and long-term rates move in lockstep, but that doesn’t hold in reality.
The Fed Funds rate, or overnight interest rate, is set by the Federal Reserve and is the interest rate at which banks lend to each other on a day-to-day basis to meet reserve requirements. This is the main vehicle the Fed uses to enact monetary policy and pursue their dual mandate of high employment rates with low inflation.
A low Feds Funds rate stimulates the economy and promotes employment by making it cheaper for banks to borrow money which encourages more lending and leads to more spending throughout the economy. On the other hand, a higher Fed Funds rate is used for protection against inflation in times where too much money is circulating causing prices to rise.
Analysis
Fed Funds Rate
Over the last 30 years, the Fed has responded to economic downturns by lowering rates on three occasions:
- Dotcom Bust (6.5% in November 2000 to 1.8% in December 2001);
- Great Financial Crisis (5.3% in July 2007 to 0.2% by the end of 2008); and
- COVID-19 (2.4% to 0.1% in 2020).
On the flip side, fear of elevated inflation led to two short-term rate increases:
- Increased from 1.0% in May of 2004 to 5.2% in July of 2006 as the economy recovered from the Dotcom Bust; and
- Increased from 0.1% in February of 2022 to 5.3% in August of 2023 to combat rising inflation post COVID.
There were no significant rate hikes in the seven years following the Great Financial Crisis, largely because inflation never exceeded 4% while averaging close to the Federal Reserve’s 2% target during this period.
Figure 1: Fed Funds Rate for 30 Years Ending June 2025
Fed Funds vs Mortgage Rates
When looking at Fed Funds and mortgage rates together, there appears to be a loose relationship.
Figure 2: Fed Funds and Average Mortgage Rate for 30 Years Ending June 2025
When looking at shorter periods of time and actual Fed Fund changes, the relationship starts to break down. As shown in Table 1, mortgage rates tend to move differently than the Fed Funds rate, especially during the listed periods where the Fed is taking action.
Table 1: Changes in Average Mortgage Rates During Periods of Fed Fund Shifts
Mortgage rates didn’t move nearly as much as the Fed Funds rates. In many instances, mortgage rates barely responded at all to Fed actions.
Why doesn’t the Fed Funds rate have a bigger effect on mortgage rates? The answer: short-term rates and long-term rates don’t perfectly mirror each other.
10-Year Treasury vs Mortgage Rates
Figure 3 compares mortgage rates with the longer-term 10-year U.S. treasury yield:
Figure 3: 10-Year Treasury and Average Mortgage Rate for 30 Years Ending June 2025
Mortgage rates tend to track the 10-year U.S. Treasury more closely, which is evident both visually in Figure 3 and numerically in Table 2.
Table 2: Changes in Mortgage Rates and Treasury Yields During Periods of Fed Fund Shifts
So, why do short and long-term rates differ? The main reasons: expected inflation and term risk.
When a fixed income investor lends money to the government, they want to be able to buy more with the interest and principal they receive in the future than they could with the amount they loaned out today. As investors, this means that if we expect inflation to be high, we are going to demand a higher yield in order to buy long-term bonds that are exposed to inflation risk.
This means that changes in inflation expectations influence the difference between short and long-term rates. An example of this is what happened in 2021.
At the beginning of 2021, large stimulus packages were being rolled out for economic relief from the COVID pandemic. This caused long-term inflation expectations to rise from 1.9% to 2.6%. While the Fed had not increased short-term rates, inflation expectations drove the 10-year treasury yield up by 0.8%, and mortgage rates followed suit, rising 0.5%.
In addition to inflation, investors demand compensation for term risk—the uncertainty that comes with lending money over a long horizon to compensate them for potential future changes in rates. The further out the maturity, the greater the chance that economic conditions, Fed policy, or inflation could change in unexpected ways. To take on this added uncertainty, investors require an additional yield premium on longer-term bonds. This risk premium helps explain why long-term interest rates are typically higher than short-term rates, even when inflation expectations are stable.
Conclusion
In summary, the Federal Reserve influences short-term interest rates through the Fed Funds rate; however, mortgage rates are primarily driven by long-term rates, especially the 10-year U.S. Treasury yield. Understanding this distinction helps explain why changes to the Fed’s target rate don’t imply changes to mortgage rates. So, if the Fed decides to reduce rates in the coming months, we should not expect mortgage rates to decrease proportionately because there are other factors that influence long-term rates.
Disclaimer
This commentary is intended solely for informational and educational purposes and does not constitute legal, tax, investment, or accounting advice. It does not represent an offer to sell or a solicitation of an offer to buy any security, financial instrument, or investment interest. Any such offer or solicitation will be made only through formal offering documents and in accordance with applicable laws and regulations.
Certain statements contained herein may include forward-looking information, hypothetical illustrations, or projections. These are based on current assumptions and expectations, which are subject to change and involve known and unknown risks and uncertainties. Actual outcomes may differ materially due to factors such as financing availability, regulatory approvals, market volatility, force majeure events, competitive pressures, and other unforeseen circumstances.
No representation or warranty is made regarding the accuracy, completeness, or reliability of the information presented. Past performance is not indicative of future results.
This material may reference potential interest rate or market trends that are not guaranteed and may differ materially from actual results. The information herein should not be relied upon as a guarantee or forecast of future performance or interest rate movements.
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