What is the Federal Reserve, and how does it impact real estate?

The Federal Reserve (also known as the Fed)^[1] is the United States’ central bank, and one of the key drivers of mortgage rates. Because mortgage rates contribute to housing affordability, housing supply and the overall economy, the Fed’s policies and actions can strongly influence the real estate market. Here’s a rundown on how the Federal Reserve impacts real estate.

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How the federal reserve impacts real estate

What is the purpose of the Federal Reserve?

The main purpose of the Federal Reserve is to keep the U.S. economy healthy and stable by focusing on two goals: maximum employment and stable prices. Together, these two goals are referred to as the Fed’s “dual mandate.” ^[3]

To achieve its dual mandate, the Fed oversees U.S. monetary policy, using tools that include setting interest rates paid to commercial banks for their reserves on deposit and buying and selling securities on the open market. By using tools like these, the Fed tries to strike the ideal balance between keeping inflation at bay (2 percent is the Fed’s typical target) and promoting the highest level of sustainable employment. ^[4][5]

How does the Federal Reserve influence mortgage rates?

Though the Fed doesn’t control interest rates directly^[6] (banks are generally free to set their own rates), its decisions and policies can push mortgage rates up or down. To understand how this works, let’s look at three key pieces of the Fed’s playbook.

The federal funds rate

Banks often lend money to each other overnight to meet their cash needs. The federal funds rate (also known as the effective federal funds rate or EFFR) is an average of these rates, which informs lenders how much interest to charge on mortgages and other loans. It’s important to note that the Fed doesn’t set the EFFR itself. Instead, it sets a target interest rate range, to which banks pay close attention. ^[7]

When the Federal Reserve Open Market Committee (FOMC) gathers at one of its eight scheduled annual meetings, its members must decide whether to increase, decrease or maintain the target range for the federal funds rate.^[8]

Interest on reserve balances

To encourage banks to either increase or decrease their cash reserves, the Fed pays a risk-free overnight interest rate called the interest on reserve balances (IORB). Since the Fed does control IORB rates, it can use this rate to incentivize banks to either lend more money to other banks or keep more money in reserves.^[9]

If the Fed wants to stimulate growth, it can reduce the rate paid on reserve balances^[10]. In response, banks will lend more money to each other and to consumers, reducing mortgage rates.

If the Fed wants to slow economic growth, it can increase the rate, making it more attractive for banks to boost their reserves and earn risk-free interest from the Fed. When this happens, mortgage rates usually rise.

Open market operations

In addition to the EFFR and the IORB, the Fed can also exert influence over interest rates through its open market operations. This strategy involves the Fed buying and selling securities on the open market.

When the Fed wants to stimulate the economy, it can increase the amount of money in circulation by buying assets such as U.S. Treasurys and mortgage-backed securities (MBS), which leads to lower interest rates. 

That’s a practice the Fed employed during the pandemic, called “quantitative easing.” If the Fed wants to reduce the nation’s money supply, it can sell assets, leaving banks with less cash to loan out and increasing interest rates (“quantitative tightening”). ^[11][12]

The Fed’s MBS purchases also helped bring mortgage rates down because the increased competition for mortgage assets made investors willing to accept lower yields.

Fed independence

Federal Reserve policymakers are expected to base their monetary policy decisions on objective economic data such as employment and inflation readings, without interference from Congress or the White House. 

If investors who fund most government debt and home loans lose confidence in the Federal Reserve’s independence, its monetary policy tools may lose some of their effectiveness. ^[13]

Long-term bond yields and mortgage rates can move higher even when the Fed cuts short-term rates, if inflation continues to rise. ^[14]

When the Fed cut the short-term federal funds rate by a percentage point at the end of last year, mortgage rates went up by an equal amount when inflation moved away from the central bank’s 2 percent target.^[15]

What happens to real estate when …

… the Fed raises its target interest rate?

• Mortgage rates (usually) increase, although not always in proportion to the Fed’s moves.
• Competition among homebuyers will likely decrease.
• Home price growth will typically slow down or stop.

… the Fed lowers its target interest rate?

• Mortgage rates (usually) decrease.
• Competition among homebuyers will likely increase.
• Home prices will typically rise. 

What is the lock-in effect, and why does it matter?

Sometimes, the Fed’s policies and actions don’t immediately produce the intended result in the real estate market. For example, if rates rise, homeowners may choose not to sell because they don’t want to lose their existing low-rate mortgage. This phenomenon, known as the lock-in effect, can limit the supply of available homes, reducing overall home sales and propping up prices.^[16]

The lock-in effect is important because it can result in higher home prices even as rates increase, making homes less affordable for buyers. It can also create challenging conditions for agents because it reduces overall supply and leads to fewer sales.

The Fed: One of many factors that impact real estate

The Federal Reserve’s policies are designed to promote economic stability and health, often by influencing interest rates. Though the Fed doesn’t control interest rates directly, it can control the nation’s money supply and encourage banks to either lend more money or keep more in reserves.

Consequently, the Fed’s policies can contribute to housing supply, demand and affordability^[17]. Despite the Fed’s role in rate-setting and the overall economy, there are other factors that may contribute to home prices, from consumer confidence to location and zoning laws.

References

1. ^{^} The Federal Reserve (also known as the Fed) (www.inman.com)
2. ^{^} TAKE THE INMAN INTEL SURVEY FOR SEPTEMBER (www.research.net)
3. ^{^} dual mandate (www.chicagofed.org)
4. ^{^} monetary policy (www.federalreserve.gov)
5. ^{^} tools like these (www.federalreserve.gov)
6. ^{^} control interest rates directly (www.inman.com)
7. ^{^} effective federal funds rate (fred.stlouisfed.org)
8. ^{^} Federal Reserve Open Market Committee (www.federalreserve.gov)
9. ^{^} interest on reserve balances (www.federalreserve.gov)
10. ^{^} it can reduce the rate paid on reserve balances (www.inman.com)
11. ^{^} quantitative easing (www.inman.com)
12. ^{^} quantitative tightening (www.inman.com)
13. ^{^} Federal Reserve’s independence (www.brookings.edu)
14. ^{^} mortgage rates can move higher (www.inman.com)
15. ^{^} mortgage rates went up (fred.stlouisfed.org)
16. ^{^} lock-in effect (www.inman.com)
17. ^{^} affordability (www.inman.com)
18. ^{^} LinkedIn (www.linkedin.com)
19. ^{^} Instagram (www.instagram.com)