The Federal Reserve (the Fed) dropped their benchmark rate, the Federal Funds rate, to zero in April 2020. This rate is a monetary policy tool the Fed uses to induce and restrain levels of short-term borrowing in our economy. During business recessions, the Fed drops the target Federal Funds rate to encourage more borrowing and thus more capital investment and in time more jobs. During times of economic excess, the Fed raises their benchmark rate to reign in lending and borrowing activity to slow down capital investment and rising wages.

The Fed has stated their intention to leave the Federal Funds rate at its present zero-bound level until at least 2023. For real estate transactions, the Fed Funds rate directly affects the ARM rates paid on most commercial and some residential mortgages, whether they exist or are being originated.

In contrast, the 10-year Treasury Note (T-Note), the long-term rate which prompts rates on fixed rate mortgages (FRMs), plunged to its lowest rate on record in 2020, bouncing back to 1.08% as of January 2021, and rising as the third round of stimulus becomes a reality. Heading into the 2020 recession, declining business activity led bond market investors to accept significantly lower yields in return for the safety of treasuries and shun investment in mortgage-backed securities (MBS). Today, the only lender to keep interest rates on track with the T-Note is the Fed, which purchases most MBS and thus is the source of funds for FRM originations for a few years.

By 2024, the recession will fade in the rearview mirror due primarily to massive stimulus spending. Stimulus in 2021 is propping up the economy by providing funds for the unemployed to spend and businesses to remain open as employers. With the Fed Funds and FRM rates controlled by the Fed until the recovery gets underway, likely around 2024, real estate professionals can expect FRM rates to remain at levels around 1.5% above the 10-year T-note. When FRM rates begin to consistently rise, buyer purchasing power will decrease and annual home sales volume and prices will decline, unless offset by wage increases.

Jan 2021


Jul 2020


Jan 2020

(One year ago)

Federal Funds rate 0.09% 0.09% 1.55%
10-year Treasury Note rate 1.08% 0.62% 1.76%

The Fed’s toolbox contains interest rates 

The Federal Reserve’s (the Fed’s) goals are to maintain:

  • stable prices;
  • maximum employment; and
  • moderate long-term interest rates.

The Fed’s main tool to control wages and inflation in the economy has long been the Federal Funds rate. This is the rate charged on overnight funds lent to banks by the Fed. In turn, banks lend short-term funds to businesses and consumers to finance purchases of goods and services.

When the Federal Funds rate, known colloquially as the short-term rate, increases, banks are discouraged from borrowing as their cost of borrowing from the Fed increases. When the Fed Funds rate falls, banks are motivated to borrow since Fed funds are less expensive. In turn, banks tend to lend with greater or lesser frequency to businesses and individuals based on the lower or higher rates.

Long-term rate movement reflects bond market investor perception about the level of success the Fed rate will achieve fighting inflation (or deflation) in wages and consumer goods and services. When the Fed’s inflation fight becomes aggressive, the long-term bond rates decline as investors pile back into bonds.

As seen in the chart above, recessions (marked by the gray bars on the chart) coincide with decreases in the Fed Funds rate. Specifically, when the economy enters a recessionary period, the Fed decreases their benchmark rate, making funds cheaper to borrow for banks and in turn consumers. This injects stability into the economy and lessens the depth of a recession.

Following a recession and entering into the recovery portion of a business cycle, the Fed gradually increases the Federal Funds rate. This rate increase is the Fed’s attempt to maintain a lid on the boiling pot to avoid an over-heated economy — evidenced by rapidly increasing asset prices and consumer inflation.

If the pot boils over into economic excess, the recession that follows is long and hard — as most recently experienced in the Great Recession of 2008. That recession and following recovery were the longest such events since the Great Depression, and no wonder as it was the consequence of the wild, untamed decades of deregulating financial market activity culminating with the Millennium Boom and 2010 congressional re-regulation.

The link between rates

A glance at the chart above demonstrates for the casual observer that the Federal Funds rate and 10-year Treasury Note rate are linked. But what is the connection?

Movement in the Fed’s short-term rate directly alters adjustable rate mortgage (ARM) rates. The persons first affected by ARM rate movement are property owners whose properties are encumbered by ARMs. These owners will see their monthly payments soon increase or decrease when the Fed rate is adjusted, subject to ceiling and floor thresholds in their ARM note.

When the Fed rate increases during a recovery, pricing in the real estate market will lose support and sales volume will begin to slip. The opposite market reaction is induced when the Fed rate declines in a recession, as occurred in 2020 and 2021.

ARM rate movement is tied to figures in one of several indices, each directly reflecting the Fed’s short-term rate movement. So, when the Fed raises rates, these index figures rise, and in turn ARM rates rise an equal amount.

However, the Fed rate’s effect on fixed rate mortgages (FRMs) is harder to pin down as FRMs are only indirectly and belatedly influenced in reaction to the likely wage and inflation result of the short-term rate activity. For FRM analysis, the 10-year Treasury Note (T-Note) is the most influential rate to watch for setting the FRM rate and controlling its movement. The 30-year amortized FRM rate historically runs roughly at a 1.5% spread above the 10-year T-Note.

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Current market rates

10-year T-Notes are purchased by investors looking for a long-term safe place to park their money. In times of protracted economic uncertainty, investors from around the world pour money into 10-year T-Notes—as occurred in the first half of 2020 at the outset of the global 2020 recession. This surge in demand for bond investments increases the price of the 10-year T-notes while decreasing the rate of yield – interest rate earned on T-Notes.

When the Fed raises the short-term rate to bring on a routine slowdown in the national economy needed to cool wages and consumer inflation, the 10-year T-Note rises around the same time to accommodate the perceived risk of future inflation. The Fed increases the short-term rate in anticipation of economic improvement (reflected via inflation and excessive increases in wages). In turn, investors in the 10-year T-Note re-direct their investments to other more profitable sources of growth, which become more readily available in the growth experienced as the U.S. economy heads into an expansion.

In turn, FRM rates rise and fall along the path taken by 10-year T-Note rate, as well as the Federal Funds rate — both in anticipation of increased or decreased economic activity. Conclusion: The Fed fights inflation and bond investors hunt for investment opportunities in an expanding economy – until investors don’t when the Fed ramps up to aggressively fight excessive consumer inflation.

Federal Open Market Committee (FOMC) “Dot Plot”

The Fed’s members meet eight times a year in what is known as the Federal Open Market Committee (FOMC). During these meetings, the Fed sets their plans and goals for monetary policy. As part of their policy decisions, the FOMC sets their projections and targets for the Federal Funds rate.

Source: FOMC Summary of Economic Projections, December 2020.

The chart above shows each FOMC participant’s projection of the target Federal Funds rate in the future. Each dot represents a member’s projection. For example, all FOMC participants believe the rate will remain at its present zero-bound rate in 2020 (an easy guess, since this plot was created in December 2020) and in 2021. Just one member believes the rate will rise in 2022, but by 2023 a handful of members see the rate rising above zero, while the majority still believe it will remain at zero in 2023.

Over the long run, the FOMC see the Federal Funds rate returning to around 2%-3%.

The Fed’s new policy looks beyond interest rates

In 2020, the Federal Funds rate the Fed sets to influence the economy has returned to the zero lower-bound rate. A zero rate constrains the usefulness of the Fed Funds rate to further motivate investment, create jobs, or increase inflation by dropping the rate lower.  Even when rates linger at the zero lower-bound rate, the Fed is not willing to lower rates into negative levels to help lift the nation out of a recession.

So, the Fed turns to other tools to realize its inflation and employment goals.

To this end, the Fed has reset its annual inflation goal to reach and maintain an average 2% annual consumer inflation rate over time, a feat rarely achieved during the 2010’s recovery from the Great Recession of 2008. Translation: after long periods of low inflation (such as during a recession), the Fed will allow inflation to rise above its 2% target for a few years to bring the annual average over a business cycle up to its 2% average annual goal.

This approach will lead to a higher inflation rate in some years and temporarily translate to more expensive goods and services. The Fed reasons that a temporary higher level of inflation will sustain a more robust forward economy and jobs market. In turn, more individuals will be employed putting more dollars into consumers’ pockets to make up for higher prices.

With this approach by the Fed, the recovery period for the years following the 2020-2021 recession will be a series of strong short-term growth with moderation of economy activity between them – mini-recessions of great frequency compared to the decade long periods between recessions from 1982 to 2020.

To meet this average-annual inflation goal, the Fed will allow interest rates to run low for longer periods of time, stimulating investment and lending. This will generate a hotter economy for a couple of years to bring about the average annual inflation over a business cycle to 2% – which it has not averaged in a couple of decades.

Editor’s note — One reason we have not had sufficient consumer inflation is that the Fed has refused to lower rates below zero and go negative — lending to banks at a rate of, say, minus 2%, which enables banks to make more loans at ever lower rates. Of course, this would compel banks to charge depositors for holding their savings.

Higher inflation for short periods means long-term investors will need to demand higher rates of return to make their investments worthwhile during those periods. For income-producing real estate sales, capitalization rates will increase driving prices down. When it comes to the bond market, that means higher interest rates, which will bump up FRM rates, too.

The Fed won’t begin acting on its new 2% average annual inflation policy by allowing amounts of inflation greater than 2% until the U.S. economy has moved beyond the 2020-2021 recession into a recovery, say, 2025.

What do the Fed’s new policies mean for housing?

Over the next two-to-three years into 2023, FRM interest rates will remain near their present yield spread of 1.5% above the 10-year T-note rate (down from a spread of around 2.5% in 2019. This will keep buyers interested in purchasing homes and homeowners encouraged to refinance, unless the 10-year T-notes experience an exodus of bond investors seeking better investment opportunities elsewhere. Thus, buyer and owner activities based on low T-note and FRM rates will keep home prices somewhat buoyed in the 2021-2022 period. But since interest rates will not go lower without the Fed “going negative,” the impact of Fed activity on the real estate sales volume and prices will diminish so long as today’s low rates linger.