The Federal Reserve will keep its target rate for the federal funds overnight rate at zero to 0.25 percent, and continues to expect that economic conditions are likely to warrant "exceptionally low levels of the federal funds rate for an extended period."

The Federal Open Market Committee, in announcing the decision to keep the key short-term rate unchanged, said activity in the housing sector has increased over recent months. While household spending appears to be expanding, it remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.

The Federal Reserve will keep its target rate for the federal funds overnight rate at zero to 0.25 percent, and continues to expect that economic conditions are likely to warrant "exceptionally low levels of the federal funds rate for an extended period."

The Federal Open Market Committee, in announcing the decision to keep the key short-term rate unchanged, said activity in the housing sector has increased over recent months. While household spending appears to be expanding, it remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.

Businesses are still cutting back on fixed investment and staffing, the committee said, but at a slower pace, and they are making progress in bringing inventory into better alignment with sales.

With "substantial resource slack" likely to continue to keep a lid on prices, and with longer-term inflation expectations stable, the committee expects inflation will "remain subdued for some time."

Some adjustable-rate mortgage (ARM) loans are tied to the federal funds rate, but most are linked to another short-term rate, the London Interbank Offer Rate (LIBOR).

The federal funds rate and LIBOR are both expected to go up if the economy grows too quickly and inflation gets out of hand, which could make it more difficult for ARM borrowers to make their mortgage payments.

Yields on long-term Treasury bonds could also head up, which could put pressure on fixed-rate mortgages, reducing the purchasing power of prospective buyers and diminishing the benefits of refinancing. …CONTINUED

About nine in 10 mortgage loans originated today are guaranteed by Fannie Mae, Freddie Mac or the Federal Housing Administration (FHA), and the government has helped keep mortgage rates down by buying up mortgage-backed securities that finance those loans.

Rates on 30-year fixed-rate mortgages hit a low of 4.78 percent in April, a record in surveys conducted by Freddie Mac since 1971.

But the Fed will wrap up by the end of March $1.25 trillion in purchases of mortgage-backed securities (MBS) issued by Fannie Mae, Freddie Mac and Ginnie Mae, and that will put pressure on long-term interest rates and the "spread" between mortgage rates and Treasurys, Mortgage Bankers Association Chief Economist Jay Brinkmann said in a forecast issued last month.

The MBA projects that 30-year fixed-rate mortgages will average 5.4 percent next year, 6 percent in 2011, and 6.3 percent in 2012 (see story).

The Fed had originally planned to end its MBS purchases this year, but announced in September that it would stretch the program out for another three months. In its statement today, the Open Market Committee reiterated its plan to wrap up MBS purchases by the end of the first quarter, and said it will probably end up purchasing $175 billion in Fannie and Freddie debt, instead of the $200 billion originally announced.

The MBA expects 10-year Treasury yields will climb from 3.2 percent in 2010 to 4.6 percent by 2012, but that the "spread," or difference between Treasury yields and 30-year fixed-rate mortgage rates, will narrow from about 190 basis points today to 170 basis points by 2012.

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