What the Fed's Decision Means for Mortgage Rates

The central bank moves to keep its key interest rate at essentially zero.

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The Federal Reserve today left its benchmark interest rate unchanged at virtually zero as it indicated that the economy—while still fragile—appears less imperiled than it did several months back. "Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing," the central bank said in its statement. "Conditions in financial markets have generally improved in recent months." The announcement comes amid growing concern over mortgage rates, which have surged in recent weeks. Elevated mortgage rates threaten to upend President Barack Obama's plans to revive the housing market—and the economy as a whole—by limiting home loan refinancings and putting additional downward pressure on residential real estate prices. To that end, here is a step-by-step way to evaluate what today's announcement from the Fed could mean for mortgage rates:

1. Mortgage rate trends: Thirty-year fixed mortgage rates plunged to new lows after the Fed announced a series of initiatives beginning last fall, such as purchasing Fannie Mae and Freddie Mac mortgage-backed securities and long-term treasury bonds. But late last month, rates began to spike, surging from 5.03 percent on May 26 to 5.81 percent on June 11, according to HSH.com. The run-up was sparked by mounting concerns over government spending and potential inflation, which pushed yields on 10-year treasury notes—which fixed mortgage rates typically track—sharply higher. More recently, rates have retreated modestly, hitting 5.59 percent yesterday. Still, they remain significantly higher than the all-time lows of less than 4 percent reached during the winter.

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2. Treasury yields up slightly: Ten-year Treasury yields stood at 3.69 percent late this afternoon. That's up about 0.12 percentage points from before the Fed's announcement, according to Mike Larson of Weiss Research, who called the move "a fairly large intraday reversal." Larson said the increase in yields was linked to disappointed bond traders, who had hoped that the Fed would explain how it planned to one day exit its lending and liquidity programs. The statement, however, made no mention of unwinding such initiatives.

3. Fed intervention: Back when rates were approaching the 6 percent range, some observers believed the Fed might decide to jump in and unveil plans to buy up additional treasury debt or mortgage backed securities in an attempt to drive long-term rates lower. But expanding the asset purchase program is risky, as the additional government debt needed to finance such purchases could stoke fears of future inflation and actually prod mortgage rates higher. But the Fed made no mention of expanding these programs in today's statement. "This indicates that the committee will now wait and see how the implemented monetary (and fiscal) policies will work out and that it will likely refrain from expanding the existing monetary policy programs designed to bring down long-term interest rates, unless the economic conditions take a turn for the worse," Katrin O'Connor, a staff economist at the National Association of Federal Credit Unions, said in a report.

4. Rate hike: Although there had been some speculation that the Fed might begin increasing its benchmark interest rate—the federal funds rate—before the end of the year, the central bank's statement appears to indicate otherwise. The Fed "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period," the central bank said in its statement. Keith Gumbinger of HSH.com says the Fed's statement signals to the market: "Forget about rate hikes; they are not coming [anytime soon]." Although mortgage rates don't move in lock step with the federal funds rate, increases can push rates higher. The American Bankers Association's Economic Advisory Committee—which is made up of top economists from big banks across the country—predicted in mid-June that the central bank will hold the federal funds rate in its current range until the third quarter of 2010.

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5. Inflation in check: Although the possibility of a future surge in inflation has worked to push 10-year treasury yields—and therefore fixed mortgage rates—higher, the Fed signaled it doesn't consider inflation a pressing concern. "The prices of energy and other commodities have risen of late," the Fed said in its statement. "However, substantial resource slack is likely to dampen cost pressures, and the committee expects that inflation will remain subdued for some time." The Fed's inflation outlook gives credibility to its stated intent to leave the federal funds rate "exceptionally low" for a long time and could help to assuage concerns about future inflation in the bond market.

6. Fed flexibility: While it didn't announce plans to expand its asset purchase or lending programs, the Fed did signal flexibility in operating them. "The committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets," the statement read. "The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted." Gumbinger says this wording suggests that the Fed might not end up buying up all the treasury bonds and mortgage-backed securities it previously indicated it would. "It leaves open the possibility that they might not even spend all of the money they have committed to [the asset purchase programs] if the economy doesn't warrant it," Gumbinger said. "That eases up the concerns about the monetization of debt and the potential for inflationary pressures being stoked by that."

7. Mortgage rate outlook: Larson says that although 10-year treasury yields moved higher following the Fed's announcement, it's still too early to tell what impact today's developments will have on mortgage-rate trends. "A lot of times it kind of takes 24 to 48 hours to sort out what the trend is going to be—the first 15 minutes after the Fed's announcement is typically pretty crazy," he said. "[However,] by the end of the week, if we are still selling off in the bond market, then you are going to see more upward pressure on mortgage rates."