Measuring the Impact of Monetary Policy on Mortgage Rates

This study examines the impact of United States monetary policies on domestic mortgage rates, incorporating a holistic set of macroeconomic variables in its analysis. Two obstacles have prevented this integration in the past: the data gap in the federal funds rate during the zero lower bound (ZLB) period; and the utilization of a single equation rather than a system of equations to model the relationship between the mortgage rate and its determinants. First, we establish that the shadow federal funds rate introduced by Wu and Xia (2015) is a valid proxy for monetary policy during the ZLB period, and we use dimensionality reduction to create proxy variables for important macroeconomic measures. Second, we utilize the generalized impulse response approach to measure in level and first difference the impact of monetary policy and the macroeconomic environment on the long-term mortgage rate. Generally, the effect of macroeconomic variables outweighs that of monetary policy. In addition, omitting macroeconomics variables overestimates the impact of monetary policy on the mortgage rate in level and first difference. For example, shocking the first difference (level) of the federal funds rate by one standard deviation overestimates the impulse responses by 15% (51%) and the variance decompositions by 27% (37%). The current research implies that a noticeable increase in the mortgage rate is associated with an economic environment characterized both by tightening monetary policy and strong economic growth. Further, the impact of monetary tightening on the mortgage rate is expected to weaken if secular stagnation continues to prevail.