When the Fed believes, as this has been the case for a while now, that the US economy is overheating because inflation is rising too quickly, they raise the federal short–term funds rate to keep inflation in check which has a direct impact on mortgage rates.
As a reminder, the federal funds rate is the interest rate at which banks and depository institutions lend excess reserves to each other overnight. The most common and direct method the Fed uses to influence the federal funds rate is through open market operations. In this process, the Fed buys or sells U.S. government securities (such as Treasury bills, notes, and bonds) in the open market.
When the Fed buys U.S. government securities in the open market it injects money into the banking system, increasing the reserves available to banks. As a result, it lowers the federal funds rate as well as the mortgage interest rates. This strategy was used by the Fed during and right after the COVID-19 pandemic to maintain and stimulate economic activity.
Conversely, when the Fed sells securities in the open market, it removes money from the banking system. When there's less money available, banks must compete to borrow the remaining funds in the federal funds market, which drives up the federal funds rate and consequently leads the banks to increase their mortgage rates.
As a result, when the Fed raises the federal funds rate to combat inflation, the cost of borrowing for homebuyers increases. As mortgage rates rise, some potential buyers may be priced out of the market and/or decide to postpone their home purchases, leading to a decrease in the overall buyers’ demand.
Reduced buyers’ demand can put downward pressure on home prices as sellers may need to adjust their pricing expectations to attract buyers. Likewise, with fewer buyers in the market, homes may take longer to sell.
Slower sales and reduced demand may lead to an increase in housing inventory, which could contribute to creating a buyer's market after a while (more properties to choose from for the buyers).
Higher mortgage interest rates can also discourage homeowners from refinancing their existing mortgages and increase the cost of financing for homebuilders, leading to a slowdown in new residential construction activity.
Higher mortgage rates could may increase the risk of mortgage defaults in the long run, particularly among borrowers with adjustable-rate mortgages or those on the margin of affordability.
Lastly, investors in the real estate market may see changes in the attractiveness of investment properties as the cost of financing increases.
That said, always bear in mind that the impact of rising mortgage rates will vary from one neighborhood to another. To put it simply, at a micro level the magnitude and timing of the above-described consequences will vary based on the extent of the interest rate hike and the conditions of the housing market for a given r neighborhood.
Hope this helps;