How does the Fed track the economy and how could it give you some insight into where mortgage rates might be headed? Before we get there, let’s take a look at the one thing the Fed controls. The federal funds rate is the Fed’s primary tool for controlling inflation. When inflation is getting out of hand, they raise the target rate. When it seems like the economy is slowing down, the target gets lowered to stimulate growth. When it’s more expensive for financial institutions to borrow money, that cost is directly passed on to the consumer. On the other hand, when the federal funds rate range is lowered, consumers benefit from lower rates and easier borrowing. While the federal funds rate doesn’t drive mortgage rates, it does affect them. We’ve mapped the relationship between the federal funds rate and mortgage rates below. There’s no single number that signifies maximum employment. In fact, if you look at the average of the unemployment rate during a recession vs. when we aren’t in a recession, the difference in records going back to June 1976 is less than 1%. Does that mean that we experience no significant difference in employment in a recession? No. Rather, what’s happening now is that we have more people employed in recent years than we have at any point in history. The unemployment rate right now is 3.8%. In January and April of this year, the unemployment rate hit 3.4%, the lowest that number has ever been.Federal Funds Rate
Unemployment
The most commonly occurring unemployment rate in the data we looked at is 5.4%. The median rate is 5.8%. The point is, we are at abnormally low levels and it wasn’t so long ago that an unemployment rate of 5% was considered full employment.
Now we’ve somewhat reached a new normal. Think about all the shifts that have taken place in the economy within the last 10 years. Technological change, accelerated by the pandemic, created opportunities for remote work and an entirely new class of gig worker. That has reset expectations.
Jobless Claims
In the Federal Reserve’s latest economic projections, the median expectation is that in the long run, unemployment is likely to be 4%. But in addition to the unemployment rate, it can also be helpful to look at jobless claims.
As a recent example, we chose to look at the period from 2015 through January 2020. This represents a time when the economy should have sufficiently recovered from the recession from December 2007 – June 2009, but before the COVID-19 pandemic hit in February 2020.
During this time, the average number of initial claims for unemployment was 243,699. The unemployment rate in January 2020 was also similar to what we have today, running at 3.6%.
It’s impossible to predict exactly when the Federal Reserve would likely be forced to act and drop rates as a result of higher unemployment claims or the unemployment rate itself. There’s a balancing act between a desire to control inflation and having maximum employment.
Again, unemployment rates do not drive mortgage rates but, if you look over time, mortgage rates usually fall in response to recessions.
Inflation
If the Federal Reserve feels that inflation is going to remain high, they end up raising the target for the federal funds rate to try to bring inflation down. That could push mortgage rates up.
On the flipside, if prices are falling, the Federal Reserve could choose to lower interest rates on the assumption that people will be willing to spend more money, which stimulates the economy but can push prices higher. If people think prices are going to fall, they may wait to buy, which hurts production and employment.
Inflation is the #1 issue on the Fed’s radar right now. There are lots of reasons it’s currently higher than the Fed’s 2% target.
During the pandemic, there were supply chain disruptions, which meant prices were higher for many goods and services. Additionally, the government injected stimulus money into the economy, which gave people more money to spend.
One key the Fed is likely keeping an eye on is not only getting inflation down to its target but making sure wage growth is keeping up. If it isn’t, people end up with decreased spending power even if they’re getting raises.
The Federal Reserve may not choose to lower the federal funds rate until inflation comes down to where they want to see it. They’re trying to do this without causing a recession.
Treasury Yield Curves
Treasury bonds are used to fund government operations. The investor buys a bond that funds the government. When the bond matures, they can cash in the bond for their original investment plus the interest rate determined by the yield.
In a healthy economy, longer-term bond yields are higher than shorter-term ones because the investor should get more interest for their money being tied up longer. However, bond yields are also determined by market demand.
If people believe the economy is going to be worse in the short run, they start willingly tying their money up in longer-term bonds, which drives the yield down. If enough investors buy these bonds, the 2-year yield ends up higher than the 10-year yield. This is referred to as an inverted yield curve. The data shows that the U.S. often goes into a recession within about a year and a half.
Recessions are historically correlated with lower mortgage rates.
The direction of the 10-year Treasury yield tends to correlate with the 30-year fixed mortgage rate. You’ll find they go in the same general direction despite the fact that MBS and the treasury aren’t the same.
