What will the Fed do next?  Greater Home Loans doesn’t know – nor do most economists.  How does the Federal Reserve affect you as a potential homebuyer?

First, what is the Federal Reserve System?

The goal of the Federal Reserve is to maintain a stable financial system through monetary policies, facilitation of US dollar transactions and payments, analysis of consumer trends, as well as other responsibilities. The system is led by the Board of Governors, aka the Federal Reserve board, which is located in DC. The board is made up of seven governors, who are appointed by the President and then confirmed by the Senate and they each serve fourteen-year terms. The chairman and vice-chairman have four-years terms but have the opportunity to be reappointed, depending on term limitations.  The position of Chairwoman is currently held by Janet Yellen. The Federal Reserve has the power to lower or raise interest rates via the Federal Open Market Committee (FOMC). The FOMC is made up of the twelve members;  seven governors from the Board of Governors, the President Federal Reserve Bank of New York, and four of the remaining eleven Reserve Bank president. The four Reserve Bank presidents each serve one-year terms on a rotating basis. They meet eight times a year to discuss whether they should adjust the federal funds rate and the federal discount rate.

What tools do the Federal Reserve have?

The first tool is the reserve requirements:

Banks make money off of loans (via interest) so they are incentivized to make as many loans as they can. This will become a problem if depositors come to collect their money and the bank has already loaned it all out in the form of too many loans . In an effort to prevent this from occurring, the Federal Reserve sets reserve requirements. These requirements require depository institutions, like banks or credit unions, to have a certain amount of cash on hand.

Now let’s say at the end of the day a bank’s reserves fall short from the reserve requirements. They then have the choice of borrowing the money from other banks or the Federal Reserve itself. These short term, typically overnight, loans.

  • If the bank is borrowing from the Federal Reserve, they receive the Federal discount rate – This is the rate at which the the Federal Reserve charges banks to take out short (typically overnight) loans.
  • If the bank are borrowing from other banks, they receive the Fed Funds rate – The rate at which banks can borrow from federal reserve banks or from other banks with money at the federal reserve.

It is important to note that banks most frequently borrow from other banks. Borrowing from the Federal Reserve is viewed as a “lender of last resort” or a lender when banks have exhausted all other options. The Federal discount rate is more generally used as a tool to influence the Fed funds rate.

Why does the Federal Reserve change the rates?

The Fed is only actually capable of setting the discount rate which influences the Federal Funds rate. This is why the Board of Governors will set a target rate for the Federal Funds rate instead. Currently, the target for Federal Funds rate is currently set between 0.25-0.50. Typically when the discount rate lowers the Fed Funds rate follows suit and it is the same when the discount rate raises. The Federal Reserve can also impact the Fed Funds rate by affecting the money supply. They do this by buying and selling bonds, which will either push the rate up or down.

  • When the Fed buys government bonds they are flooding the money with cash. This makes it easier for banks to make loans, so they will do it at a lower rates.
  • When the Fed sells government bonds they are taking money out of the money supply. This makes it more difficult to make loans, so they will raise rates.

The Federal Reserve will make these changes in an effort to curb inflation.  What’s wrong with inflation? Well, inflation is defined as the rate that the general level of price for goods and services is rising and, in turn, the purchasing power of currency is falling. For example, let’s say that you went to the grocery store last month and bought a basket of items which cost you twenty dollars. Now, let’s say that the inflation rate increase to three percent next month, and you go to the grocery store to buy those same basket of items. That same basket will now cost you twenty dollars and sixty cents due to inflation. Basically, you will need more money as inflation reduces your purchasing power, or your money does not go as far as it used to. The Fed works to keep the inflation rate low and your purchasing power high by influencing the market.

How does this influence you as a homebuyer?
A low interest rate at the federal reserve typically means that you will have a lower mortgage rate. Remember, the Federal Reserve does not dictate mortgage rates but their role with the money supply affects mortgage rates. When the Fed tries to stimulate the economy, through pushing Fed fund rates lower, it typically makes it easier (and cheaper) for you to get a mortgage. When the Federal Reserve pushes the Fed funds rate higher it will then become more difficult for you to get a loan or the rate while be higher, because the federal reserve is trying to slow down economic activity. The Federal Reserve has kept really low and steady rates for a while now and is looking to increase them shortly. This means that it wouldn’t be surprising to see mortgage rates going up shortly. If you are a potential homebuyer that is worried about a mortgage rate hike, I would advise you to go talk to your mortgage broker and look at your options for getting that rate locked in!