Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Influence Mortgage Rates Beyond the Policy Rate
Transcript
- Lucas: When the Federal Reserve cuts its policy rate by a quarter point, most people assume mortgage rates fall by roughly the same amount. But that's not how it works, and the gap between those two numbers tells us something important about how central banks actually shape long-term borrowing costs. Luna: Right — because mortgages are tied to long-term bond yields, not the overnight rate. So the transmission mechanism is a lot messier. Lucas: Exactly. The policy rate directly influences short-term rates, but a thirty-year mortgage is priced off the ten-year Treasury yield, plus a spread for prepayment risk and servicing costs. And that ten-year yield has two components: expectations of future short-term rates, and something called the term premium. Luna: Which is basically the extra compensation investors demand for holding a long-dated bond instead of rolling over short-term bills. The risk that inflation or policy surprises could eat into returns. Lucas: Precisely. And the term premium is where central banks' balance sheet policies have their stealthiest impact. When the Fed does quantitative easing — buying long-term Treasuries and mortgage-backed securities — it reduces the supply of duration risk that private investors have to hold. That mechanically compresses the term premium. Luna: So you get lower mortgage rates even if the fed funds rate hasn't budged. That's what happened in 2020, right? Lucas: Dramatically so. The Atlanta Fed publishes a model that decomposes the ten-year yield into expectations and term premium. In early 2020, just before COVID, the term premium was around zero. By mid-2020, after the Fed had bought over a trillion dollars in Treasuries and MBS, the term premium had fallen to about negative one percent. Negative. Luna: Meaning investors were effectively paying for the privilege of holding long-term government debt. That's wild. Lucas: It is. And that negative term premium pulled the ten-year yield down to around 0.6 percent, which in turn pushed thirty-year mortgage rates below 2.8 percent — a record low. If you isolate the effect, the Fed's asset purchases probably accounted for about 1.2 percentage points of that mortgage rate decline, separate from the fed funds rate cut. Luna: So the central bank was directly engineering cheaper mortgages through the term premium channel. That's a huge policy tool that most people never hear about. Lucas: It's one of the most powerful but least understood transmission mechanisms. And it cuts both ways. When the Fed started quantitative tightening in 2022, letting its balance sheet shrink, you'd expect the term premium to rise back up and push mortgage rates higher. And mortgage rates did spike — they hit 7.8 percent in late 2023. But the term premium didn't rebound symmetrically. Luna: Why not? If QE compresses it, QT should expand it. Lucas: That's the theory, but the data shows a more complicated story. The Atlanta Fed's term premium estimate did rise, but only to about 0.3 percent by late 2023 — nowhere near the positive one percent or more you might have expected given the size of the balance sheet unwind. Part of the reason is that private investors had already positioned for tighter policy, and the unwind was gradual and predictable. Luna: So the signaling effect — the Fed communicating that it would be patient — actually kept the term premium lower than it otherwise would have been? Lucas: Exactly. Forward guidance and balance sheet policy work together. The Fed said it would let maturing bonds roll off at a capped pace, and markets believed them. That credibility prevented a disorderly sell-off in long-term bonds. But there's another factor: foreign demand. In 2022 and 2023, foreign central banks, especially in Asia, were buying U.S. Treasuries to manage their own exchange rates, which absorbed some of the duration that the Fed was shedding. Luna: So the term premium stayed compressed even as the Fed was shrinking its balance sheet. That meant mortgage rates, while high, weren't as high as they could have been. Lucas: Right. If the term premium had risen to, say, one percent — which is historically average — the ten-year yield would have been about 70 basis points higher than it was. That would have pushed mortgage rates above 8.5 percent, with real consequences for housing affordability. Luna: I want to bring this back to something tangible. Walking through the economy with us — seeing how central bank balance sheets affect your mortgage payment — if that's made something click, it's worth mentioning that listener support is what keeps this show ad-free and independent. A couple of dollars a month genuinely makes a difference. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing that adds up. And it lets us keep digging into these mechanics without commercial breaks. So, back to the term premium — one of the reasons the Fed's unwind didn't blow out mortgage spreads is that the housing market itself changed. With rates rising, origination volume collapsed, and banks and non-bank lenders became more cautious about holding mortgage risk. Luna: Which actually reduced the supply of MBS that the Fed was no longer buying, because fewer mortgages were being originated. So the private market didn't have to absorb as much duration as feared. Lucas: Exactly. The Fed's QT was partially self-limiting in that sense. But now, in mid-2026, we're in a different environment. The Fed paused QT late last year after the 2025 debt ceiling standoff caused some reserve scarcity. Since then, the balance sheet has been roughly flat. Mortgage rates are hovering around 6.5 percent, and the term premium is back near zero. Luna: So we're essentially back to the pre covid term premium level, but mortgage rates are much higher because the expectations component — the path of future short-term rates — is higher. Lucas: That's the key distinction. In 2020, the term premium did most of the heavy lifting to lower mortgage rates. In 2026, it's expectations driving the bus. The market expects the fed funds rate to stay around 4 percent for the next couple of years, so the ten-year yield is around 4.5 percent, and mortgages price off that. Luna: So if the Fed were to restart QE tomorrow — say, in response to a recession — would the term premium go negative again? Lucas: Not necessarily. The effectiveness of QE on the term premium depends on how much duration the Fed can absorb relative to the market. In 2020, the Fed bought at a pace of $80 billion per month in Treasuries and $40 billion in MBS, and the market was in panic mode, so the impact was huge. Today, if the Fed announced a similar program, the term premium might compress by, say, 40 to 60 basis points, not 100, because markets are calmer and the Fed's purchase capacity relative to outstanding debt is smaller. Luna: So the tool still works, but the dose matters. And it's not symmetric — the same size purchase has a smaller effect when markets aren't stressed. Lucas: That's a critical insight. Central banks have to calibrate their balance sheet policies to the state of the term premium itself. If the premium is already low, additional QE might not move the needle much on mortgage rates. That's why many academics argue that the Fed should focus on shortening the average maturity of its holdings — essentially doing Operation Twist — to directly target the term premium without expanding the balance sheet. Luna: Selling short-term bills and buying long-term bonds, which keeps the size of the balance sheet constant but shifts the composition. That's a more surgical tool. Lucas: Exactly. And it's been used before, in 2011 and 2012. That program compressed the term premium by about 20 basis points, which translated into roughly 15 to 20 basis points lower mortgage rates. Not huge, but meaningful at the margin. Luna: So for a homeowner or buyer in 2026, the lesson is that the Fed's balance sheet decisions — not just the fed funds rate — are shaping their monthly payment. And that those decisions are mediated by this invisible number, the term premium, that most people have never heard of. Lucas: And that number is influenced by everything from global demand for U.S. debt to the Fed's communication strategy to the pace of housing turnover. It's a reminder that monetary policy is never just one lever. It's a system of interconnected channels, and the term premium is one of the most important for the real economy. Luna: So next time someone sees a mortgage rate move and wonders why it didn't track the fed funds rate, they'll know there's a whole other mechanism at work. Lucas: And hopefully they'll remember that the Fed doesn't control mortgage rates directly. It influences the term premium, and that feeds through to the rate a borrower sees at the bank. But there's always a layer of market dynamics in between.