The Federal Reserve’s primary tool for stabilizing the inflation rate is the federal funds rate. This is the rate at which banks borrow money from each other overnight. By doing so, the Fed can better control the money supply. If short-term interest rates are lower, for instance, money is cheaper to borrow. That increases the overall money supply in the market, pushing prices up. If, on the other hand, interest rates are higher, less money is available, and prices decrease.
When the Federal Reserve keeps short-term interest rates low, mortgage interest rates tend to be lower. This was especially evident when the Fed kept interest rates at or near 0% in response to the COVID-19 pandemic, pulling mortgage rates to historic lows.
The Federal Reserve and the bond markets react to the fluctuations in the overall economy. Typically, when times are prosperous, mortgage rates increase. When investors think a downturn is on the horizon, funds get moved back into bonds and mortgage rates decrease.
Inflation is another factor in how mortgage rates are set. If inflation is high, Americans tend to invest in stocks, since the guaranteed rate of return on bonds drops as inflation rises. For instance, if a bond pays you back 5% and the money supply increases at a rate of 3% per year, you will only get an effective 2% return. It should be noted, however, that if you already have a fixed-rate mortgage, your payment will not change based on inflation.
