Federal Reserve President Wants Fed Funds Rate to Increase to 2.5 Percent in a Year to 3.5 Percent
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That Results in a Forecast 30-Year Residential Rate of 6.43 Percent
The Federal Reserve Bank System has two charges – to enable full employment and to control inflation. One of their tools to accomplish these is the Federal Funds Rate. The Fed Funds Rate is the rate that a bank or depository institution can borrow money at on an overnight basis, expressed in an annualized rate. When the economy turns down, the Federal Reserve cuts this rate (to encourage borrowing, then spending and ultimately economic growth). In a growing economy the Fed increases this rate to induce some drag on the economy in hopes of mitigating inflation.
Changes in the Fed Funds Rate are not instantly converted into either job growth or inflation/deflation deflections as there is a time lag. But changes in the Fed Funds Rate immediately impacts the cost of capital as shown in the following analysis. Given that more than one of the Federal Reserve Bank presidents are calling for an increase in the Fed Funds rate (see the press release), the following analysis examines the relationship between the Fed Funds rate and 30-year residential mortgage interest rates.
Data in this analysis are taken from the St Louis Federal Reserve Bank and include 30-year residential rates (from Freddie Mac) and the Effective Federal Funds Rate (which averaged 0.16 percent annualized in February). Data used were monthly since January 1975.
Do The Fed Funds Rate and 30-Year Residential Mortgage Rates Move in Similar Trends?
Yes they do. While not perfectly, nor always with the same spread between the two rates, the graph shows that they do indeed generally move in the same direction. The Pearson Product Moment Correlation Coefficient between the two variables with no time lag is 0.911 and the non-parametric Spearman’s Rank Correlation Coefficient is 0.915 (both significant at the 99 percent level of confidence).
How Quickly Does a Change in the Fed Funds Rate Impact 30-Year Rates?
To test this, both parametric and non-parametric correlation coefficients were calculated. These reveal that as soon as the Fed Funds Rate changes (same month), so does the 30-year residential mortgage interest rate. The table below shows these calculated from same month to a12-month lag on residential interest rates. The bigger the number, the more they move in the same direction. As soon as the Fed Funds Rate changes, (which an over-night lending rate expressed on an annualized basis), so does the 30-year residential rate.
What Does a 2.5 Percent Fund Funds Rate Portend for 30-Year Residential Interest Rates?
Since the president of the Federal Reserve Bank of Philadelphia states in the press release below that the Fed Funds Rate should be at 2.5 percent within a year (from 0.16 percent in February 2011) how much will 30-year residential rates increase? To answer this, a regression is used to estimate the 30-year rate (the dependent variable) as a function of the Fed Funds Rate (the independent variable). The regression model and associated statistics are listed below.
This model is statistically significant with a massive F statistic and an adjusted R Square of 0.829. Ditto the significance of the intercept and coefficient of the independent variable.
A 2.5 percent Fed Funds Rate would forecast 30-year residential rates at 6.43 percent.
The graph below shows actual and forecast 30-year residential mortgage rates from this model since 1975.
The bottom line is that residential interest rates will likely increase in a year to the mid 6 percent level, assuming the Philadelphia Federal Reserve Bank president is correct in forecasting a 2.5 percent Fed Funds Rate in a year.
For any that are interested in these data and statistics, the attached Excel Sheet has the data, the correlation table (at the bottom of the data) and the regression model (to the right of the data).
Fed's Plosser: Funds rate should hit 2.5% in year - marketwatch.com