The Federal Funds Rate & Its Ripple Effect on Real Estate

Have you ever heard of the Federal Funds Rate? It is one of the Federal Reserve’s tools for influencing monetary policy and controlling the nation’s economy. Simply put, the Federal Funds Rate is the target interest rate range set by the Federal Open Market Committee (FOMC) for commercial banks as they borrow and lend their excess reserves overnight. On the surface, the Federal Funds Rate is all about bank-to-bank lending, but it has a ripple effect that reaches to every corner of the economy–including the California real estate market. 

Think of the Federal Funds Rate as the first domino that begins a trail that eventually touches the domino for real estate interest rates somewhere down the line.

If the first domino falls harder or softer, faster or slower, it is going to matter. As the Federal Funds Rate affects the economy as a whole, it indirectly affects real estate lending and interest rates, and it can be helpful to understand it better.

Key Points:

• The Federal Funds Rate directly concerns bank-to-bank lending
• The Federal Funds Rate indirectly affects how much banks charge people when they borrow money. Thus, it also indirectly affects interest rates on loans, like mortgages
• The Federal Open Market Committee (FOMC) adjusts the Federal Funds Rate with the goal of stabilizing prices and maintaining a healthy economy

Bank-to-Bank Lending

Every financial institution is required to reserve a certain percentage of their total capital each day. As people withdraw money and banks approve loans throughout the day, their total capital fluctuates, and they may not end up with enough money to meet the reserve requirement. Another bank may have excess reserves, so they’re willing to loan the other bank the difference in their reserve. 

That’s where the Federal Funds Rate comes in. Every night, banks lend to and borrow from one another, and unsurprisingly, they don’t do it for free.

The lending bank charges the borrowing bank interest, and they determine what the interest rate will be based on the Federal Funds Rate. 

Why the Federal Open Market Committee (FOMC) Changes the Federal Funds Rate

The FOMC sets a target rate for federal funds eight times each year, and they do so strategically. We can better understand their methodology by looking at the FOMC’s goal. The FOMC didn’t settle on a goal arbitrarily. Congress actually assigned the Federal Reserve a “dual mandate” to (1) maintain stable prices and (2) support maximum employment. They do all this with the ripple effect in mind of maintaining moderate long-term interest rates and creating a stable financial system.

The Federal Funds Rate and Inflation

When the FOMC wants to fight inflation in the economy, it might raise the Federal Funds Rate.

This makes it more expensive for banks to borrow money from each other, so they will pass on these higher costs to consumers and businesses looking to borrow in the form of higher interest rates on loans, such as car loans and mortgages. This decreases borrowing and overall demand in the economy. 

The Federal Funds Rate and Recession

When the economy is experiencing a recession or there are fears we are heading into one, the FOMC might lower the Federal Funds Rate to encourage borrowing and spending.

If banks can easily borrow from each other, they’re more likely to offer consumers and businesses lower interest rates as well. Then, more people are likely to borrow, which stimulates demand and economic activity.

A Typical Federal Funds Rate

The Federal Funds Rate has varied from a low of 0% to a high of 20% over the past 50 years, so it is hard to pin down a consistent average. In 2008, in the face of the Great Recession, and in 2020, in the midst of the COVID-19 pandemic, the Federal Funds Rate was lowered to 9%. In 2022 and 2023, the Federal Reserve continued to raise rates, and at the time of writing, the Federal Funds Rate is 5% to 5.25%. 

The Federal Funds Rate and California Real Estate

You may be asking yourself, “How does all of this affect me?” While the Federal Funds Rate directly affects short-term borrowing costs for financial institutions, we’ve seen how it can indirectly affect the real estate market. Here are the key channels through which the rate impacts the market:

a. Mortgage Rates:

The most direct link between the Federal Funds Rate and the California real estate market is through mortgage rates. Although the Federal Funds Rate doesn't dictate mortgage rates, it significantly influences them.

When the FOMC lowers the rate, banks can borrow money at a lower cost, allowing them to offer lower interest rates on mortgages. Conversely, rate hikes tend to lead to higher mortgage rates.

As mortgage rates impact the affordability of homes for buyers, changes in the Federal Funds Rate can affect housing demand in California.

b. Housing Demand:

Changes in mortgage rates driven by the Federal Funds Rate can influence housing demand in California. Lower rates may encourage prospective buyers to enter the market, as borrowing becomes more affordable.

Increased demand can drive up property prices and lead to a competitive housing market.

Conversely, higher mortgage rates might deter some potential buyers, leading to decreased demand and more balanced pricing.

c. Investment Environment:

The Federal Funds Rate also influences the overall investment environment. When interest rates are low, investors may seek higher returns in alternative assets, such as real estate. In California, a popular destination for real estate investment, this can lead to increased demand and upward pressure on property prices. However, this effect can also vary depending on other factors such as local economic conditions and investor sentiment.

d. Economic Conditions:

The Federal Funds Rate indirectly affects California's real estate market by influencing the broader state of the economy. Changes in interest rates can impact consumer spending, business investment, and employment rates.

A robust economy with job growth and rising wages can fuel demand for housing, leading to increased property values.

Conversely, an economic slowdown might dampen housing demand and potentially lead to a stagnation of property prices.

Summary

The Federal Funds Rate is the first domino in a strategy to cultivate a thriving economy. It touches directly on bank-to-bank lending, but down the line, it affects supply and demand, interest rates, and employment. Understanding the Federal Funds Rate can give you more insight into the world of interest rates and borrowing and make you a more confident and informed buyer.

Still Have Questions?

If you’re looking for more information about the financial aspect of buying a home or investing in a property, our team is always available to answer your questions. Send us an email at [email protected], and a member of our team will reach out to you.