The Federal Reserve finds itself at a pivotal moment. With observed core inflation growth mostly back to the long-run target and the labor market cooling from its post-pandemic fever, policymakers are signaling potential interest rate cuts in the months ahead.
However, the relationship between Fed policy and interest rates — like those for mortgage rates — is far more complex, and incomplete, than many realize. Several economic risks loom on the horizon that could keep interest rates for consumers near where they are now.
The Fed’s current position: Balancing act in action
The Federal Reserve is carefully threading the needle between its dual mandate of maintaining full employment and keeping inflation at its 2% target. Recent data suggest this balancing act may be working. Inflation has largely returned to target levels, with month-over-month growth rates stabilizing around the Fed’s preferred range. Meanwhile, the labor market has cooled significantly from its pandemic-era extremes.
At one point during the recovery, there were twice as many job openings as unemployed workers — a clear sign of an overheated economy. That gap has now closed, bringing the market back to a more sustainable equilibrium. The unemployment rate, while no longer at historically low levels, is chugging along at what economists consider full employment.
This normalization has given the Fed room to consider a more accommodative stance. Fed officials have indicated they feel “more comfortable potentially lowering interest rates in the months ahead,” representing a shift from the contractionary policies needed to combat inflation to a more neutral position.
How Federal Reserve policy works
Understanding the Fed’s impact on the broader economy requires grasping the mechanics of monetary policy transmission. The federal funds rate — the benchmark rate at which banks borrow from each other overnight — serves as the primary policy tool. When this short-term rate changes, it cascades through the financial system, influencing longer-term rates, including mortgages.
However, the relationship is not direct. Markets are made up of people. And people anticipate.
The 10-year Treasury yield often moves before the announcements of fed funds rate adjustments. As new data drops (for example, employment and inflation data from the Bureau of Labor Statistics), market expectations change about the future economic vitality of the U.S. economy as an investment. When economic data releases suggest the Fed might change course, bond markets react immediately.
Nor is Fed monetary policy a general panacea. The central bank can do little about potential U.S. government shutdowns, local and international unrest, rising inequality, or tariff policies counter to the economic wisdom of ages — all factors that also influence the local and global buyers of U.S. bonds.
Open market operations: The Fed’s stabilizing force
Beyond setting the benchmark fed funds rate, the Federal Reserve uses open market operations — buying and selling government securities — to influence broader financial conditions. This tool became especially prominent during the 2008 financial crisis and reached unprecedented scales during the COVID-19 pandemic.
When the government needs cash, it sells Treasury bonds that pay back a fixed amount in a set number of years. The price of the bonds can drop with extra supply if the government needs more funds. That’s how “crowding out” happens. When the price of bonds drop, their implied yields grow. (Buy now for less, get the same amount later.) Those Treasury yields are alternatives to other long-run debt for investors, so if Treasury yields rise, mortgage rates will rise too.
That’s why in times of crisis, the Fed steps in to buy Treasurys at scale, providing more demand to offset the extra supply and keep interest rates from rising despite crisis spending — and rapidly rising debt — from the federal government.
The Fed’s balance sheet tells the story of these interventions. Fed purchases expanded dramatically during the pandemic, dwarfing those made during the global financial crisis.
After aggressive inflation increasingly impacted people without high incomes and asset holdings, the Fed switched course in 2022, increased the fed funds rate and began reducing their holdings of Treasurys and mortgage-backed securities. But recent data suggest they may have slowed this process in response to emerging economic risks.
Notably, in early April — coinciding with the implementation of new tariff policies — the Fed appears to have adjusted the pace again, decreasing their holdings more slowly. This was ostensibly to make up for the loss in demand as U.S. Treasury bonds became a riskier venture in the global marketplace. The move has kept interest rates from rising more than they otherwise would have over the last several months.
The tariff question: A new variable in the equation
Trade policy represents one of the most significant uncertainties facing the U.S. economy today. While consumer prices haven’t yet reflected the full impact of these policies, the mechanism for future price increases is already visible.
Ahead of tariff implementation, imports surged as businesses rushed to stock inventories with foreign goods before prices rose. This front-loading created a temporary buffer, delaying the pass-through of higher costs to consumers. However, as these inventories deplete, price pressures are likely to emerge.
The Fed must now weigh the competing pressures of supporting economic growth while remaining vigilant about inflation. Tariffs represent a particularly challenging form of inflation because they function as a regressive tax, disproportionately affecting lower-income households that spend a larger share of their income on goods subject to these policies, like food.
Housing market dynamics: The interest rate boom
The housing market illustrates how Fed policy interacts with other economic forces in complex ways. During the pandemic, extremely low interest rates combined with supply shortages and changing housing preferences created unprecedented price growth. Home values increased at rates far exceeding historical norms, fundamentally altering affordability calculations for potential buyers.
Even as price growth has moderated, the absolute level of home prices remains dramatically elevated. A similar phenomenon occurred to a lesser degree across food prices, rent, and many services, whose prices have moderated but not dropped. Average wage growth did not keep up, so most households — especially those without exploding asset values to compensate — saw their purchasing power and livelihoods erode.
This dynamic explains why consumer confidence remains fragile despite stable macroeconomic indicators. People’s budgets remain stretched, and many households are struggling to save.
Institutional risks and market stability
Perhaps the most significant risk to current economic stability lies not in any particular policy choice, but in potential threats to institutional independence and data integrity. The Federal Reserve’s effectiveness depends on its ability to make decisions based on economic data rather than political considerations. Any erosion of this independence could undermine the central bank’s credibility and effectiveness.
Similarly, the integrity of economic data collection represents a critical infrastructure for effective policy making. All data, at its origin, is messy. It takes discipline to turn it into accurate insight.
Organizations like the Bureau of Labor Statistics (BLS) provide the foundation for economic decision-making through rigorous, professional statistical methods. Methodology changes without transparency or proper documentation, as well as destaffing and defunding, could undermine confidence in the accuracy or appropriate interpretation of the information. And that’s a problem for all of us.
Every market research team, whether within private companies, community organizations or think tanks rely on data from the BLS. Even your favorite private data providers rely on data from the BLS as inputs or benchmarks in their analytics work.
The decisions of the Fed may be far more consequential, and their need for accurate information more acute, but the capacity and validity of our federal data systems support important local business and policy decisions across the country.
Looking ahead
The Fed’s toolkit of interest rate adjustments and open market operations provides mechanisms for general response. Because they are broad, untargeted and powerful, monetary policy tools work best when supported by clear communication, institutional independence and reliable data. Maintaining these foundations will be crucial for navigating whatever economic challenges emerge in the months and years ahead.
For mortgage market participants, this suggests a period of relative stability with gradual adjustments rather than dramatic policy swings. While rates may decline modestly as the Fed moves toward a more neutral stance, borrowers shouldn’t expect a return to the ultra-low rates of the pandemic era. Instead, the focus should be on sustainable, long-term affordability solutions that don’t depend solely on monetary policy accommodation.
The Fed’s dual mandate of maintaining full employment and 2% inflation requires balancing competing objectives. In the current environment, that balance appears to be working. The challenge will be maintaining this equilibrium as new economic forces evolve.
