Here’s how the Fed doubled mortgage rates to quash inflation

Mortgage rates have soared since the Federal Reserve began its battle with inflation last spring, sending monthly housing payments to new highs. 

Average rates have moderated only slightly in the first half of the year, settling above 6 percent after averaging near 3 percent for most of the COVID-19 pandemic.

While inflation throughout the economy is cooling off, persistently high mortgage rates and high prices continue to push many out of the market and back into rental spaces or with their friends or parents. 

Shelter costs, which make up about 40 percent of core inflation, rose by 0.4 percent in April, according to consumer price index (CPI) data released Wednesday. It was also the largest contributor to the 0.4 percent monthly increase in overall inflation.

The cost for shelter has increased by 8.1 percent in the past 12 months on an unadjusted basis.

And the market could experience further volatility after the Fed raised its rates again last week. 

How the Fed affects your mortgage

Although interest rates the Federal Reserve sets are not directly tied to mortgage rates, they have a major influence on home loans, Realtor.com chief economist Danielle Hale told The Hill. 

As the Fed raises its baseline interest rate higher, Hale explained, interest rates across financial markets also rise as lenders adjust their operations.

“The overnight lending rate set by the Fed is not the mortgage rate that homebuyers get when they borrow, and the Fed does not control mortgage rates,” Hale said.   

“Rather, the fed funds rate influences all other interest rates in the market because it changes the opportunity cost calculation for banks, influencing their lending behavior,” she added. 

The U.S. central bank has raised interest rates by 5 percentage points in the past year, up from near-zero levels in March 2021. 

What goes up must come down

Prior to the Fed’s rate hikes, historically low mortgage rates helped fuel a two-year housing boom that saw prices reach their peak in June, with some markets seeing double-digit price increases.  

Fed Chairman Jerome Powell acknowledged early on that the housing market would need to go through a correction to make housing more affordable. He noted again last week that leaders are seeing the effects of their policies in the most interest rate-sensitive sectors, such as housing.    

The average 30-year fixed-rate mortgage rate shot up to more than 7 percent in November 2022 from lows below 3 percent in 2021, pushing monthly mortgage payments above $2,000 for the first time, according to Zillow. 

The benchmark mortgage rate is nearly double what it was at the beginning of 2022. 

How higher rates are shaping the housing market

Zillow senior economist Orphe Divounguy said homebuilding and sales have cooled because of Fed rate hikes, but they could kick back up if the central bank pauses hikes.

“Powell’s indication that subsequent rate increases may not be necessary was a welcome signal for mortgage rates, but the path forward still remains uncertain,” he said last week in an analysis.

The consumer price index, a key measure of inflation the Labor Department released Wednesday, showed inflation slowed in April to the lowest annual rate since 2021. 

The April inflation slowdown could give the Fed room to pause rate hikes, especially as the banking system continues to shake off the collapse of three major banks.

Several regional bank failures culminating in the seizure and sale of First Republic Bank sent mortgage credit availability to its lowest level in a decade. The average 30-year rate fell slightly for the second straight week as of May 4, according to Freddie Mac data, after rising following turmoil in the banking sector. 

Although some economists expect the latest 0.25 percentage point interest rate increase to be the last of this cycle, at least one Fed official stated there could be more. 

“We haven’t said we’re done raising rates. We made a decision in our May meeting to raise the federal funds target range … and we didn’t make a decision [about] what we’re going to do in our future meetings,” New York Fed President John Williams said during a presentation at the Economic Club of New York on Tuesday. 

Some economists, including Mortgage Bankers Association chief economist Mike Fratantoni, still anticipate this will be the last in the current series of rate hikes. 

“With this increase, we expect this is the peak rate for this cycle, and potential homebuyers and their mortgage lenders may be breathing a sigh of relief,” Fratantoni said in a statement. 

“We continue to expect that mortgage rates will drift down over the course of the year as the economy slows, as we move closer to the Fed lowering rates beginning in 2024, and as financial market volatility finally begins to settle down,” he added. 

MBA currently expects the 30-year rate to slide to 5.5 percent by the fourth quarter of 2023. 

But Fratantoni added the primary challenge hitting the housing market this year is a lack of inventory. 

“While lower mortgage rates will help with affordability, they won’t solve for the lack of inventory on the market, particularly of existing homes,” he said. “This lack of supply will continue to be the primary constraint on home sales through 2023.”