The Federal Reserve, under chairman Jerome Powell, is raising interest rates at the fastest pace in its 108-year history as part of its inflation battle. File Photo by Tasos Katopodis/UPI |
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July 25 (UPI) -- I've studied finance and financial markets since the 1970s, and I have never seen the Federal Reserve's monetary policy get such prominent news coverage as it has this past year.
And with good reason. What the Fed does has profound implications for companies, consumers and the U.S. economy, especially now as the U.S. central bank tries to tame the fastest jump in consumer prices in decades. In short, the Fed is jacking up interest rates in hopes that doing so slows the economy enough to bring down inflation.
The housing market is the sector most substantially influenced by interest rate changes, and as such, it's a key indicator of whether the Fed's plans are succeeding. To see why, I need only consider the experience of my son -- or the many other Americans hunting for a new home at a time of rising interest rates.
What the Fed is doing
First, a little background.
The Federal Reserve is raising interest rates at the fastest pace in its 108-year history as part of its inflation battle. Today's big policy steps are needed in part because the Fed and many others took awhile to understand what was causing the rise in inflation.
In fall 2021, while the pace of inflation was accelerating past 4% -- double the Fed's targeted rate -- the prevailing view at the central bank and elsewhere was that it reflected temporary disruptions following two years of COVID-19-related slowdowns. The assumption was that inflation would abate automatically as supply chains worked themselves out.
Unfortunately, that assumption proved wrong because it did not recognize how much government COVID-19 relief spending had stimulated what economists call "aggregate demand" -- in other words, the total demand for goods and services produced in an economy. Put another way, consumer spending spurred by government aid created strong demand across the economy.
And so consumer prices continued to accelerate. Russia's war in Ukraine made the problem worse, especially by driving up global food and energy prices. As of June, inflation was surging at 9.1%, the fastest pace since 1981.
While the Fed can't do much about the war or other supply-chain issues, it can address domestic aggregate demand. That's where higher interest rates come in.
Higher borrowing costs choke off consumer demand for homes, cars and other goods and services that typically require a loan, while companies pare back their investments in factories and hiring, which should ease overall inflation.
The Fed began its most recent tightening policy in March with a 0.25 percentage point increase in its target interest rate, which acts as a benchmark for other borrowing costs in the United States and around the world. Since then, the central bank has raised its target rate twice more -- by 0.5 percentage point in May and 0.75 percentage point in June.
On Wednesday, the Fed is expected to raise the rate by another 0.75 percentage point, though some observers have predicted an unprecedented 1 point increase after the June consumer prices report showed inflation was still accelerating.
Why housing market matters
The trick to reducing inflation is to choke off enough aggregate demand to tame inflation without driving the economy into recession. One of the main ways to see whether this is happening is to look at housing, which has always been particularly sensitive to rate changes and constitutes more than one-quarter of total U.S. wealth.
Because buying a house or apartment is such a large expenditure, nearly all purchasers must borrow a pretty big share of the purchase price. And just as record-low mortgage borrowing costs in 2021 helped fuel a housing market boom by lowering the cost of servicing that debt, higher rates increase the cost, discouraging housing purchases.
The average rate on a 30-year mortgage hit 5.81% in June, the highest level since 2008 and up from less than 3% throughout most of 2021. The rate currently stands at 5.54%. On a $200,000 mortgage, a 5.54% rate translates into over $400 in extra interest costs every month compared with 3%.
Confronted with such an increase, some house hunters -- like my son -- have stepped back and reconsidered whether now is the right time to buy.
Housing starting to stall
In other words, higher mortgage rates lead individuals to invest less in housing. And the effect of falling demand doesn't stop with the house. When people buy a new house, they also tend to purchase new furniture, lawn equipment, televisions and so on. And buying a used home often requires hiring contractors and others to remodel the kitchen or build a new closet in the kids' room.
So if people are buying fewer homes, they also are purchasing less furniture, electronics and lawnmowers and have less need for electricians and plumbers.
The drop in demand for all these goods and services should take a meaningful bite out of inflation. While it's still too early to say if this part of the Fed plan is working, we can already see the effects of rising mortgage rates in recent housing data.
In recent months, fewer new houses are being built, fewer existing homes are being sold and homebuyers are walking away from signed deals at the highest rate since the start of the COVID-19 pandemic.
At the same time, consumers and investors are beginning to anticipate less inflationary pressure in the next year or so.
What it means for homebuyers
As the Fed prepares to hike benchmark rates again, what does all this mean for U.S. consumers, and especially my son and other people looking for a new home?
For one thing, don't expect long-term interest rates, including for mortgages, to rise much, and certainly not by the same amount of the Fed's interest rate hike.
Investors tend to factor expected Fed policy changes into its market rates. So unless there is a surprise from the Fed, like a full 1-point hike, long-term rates are unlikely to change much. And they may even begin to fall soon, either because inflation is subdued or the U.S. slips into recession.
And while it would be nice to know how tighter monetary policy -- that is, higher interest rates -- will affect today's stratospheric house prices, this is hard to predict. The withdrawal of some buyers from the market should depress house prices by reducing demand, but sellers may also simply decide to delay selling rather than accept a lower price.
The challenge for would-be homebuyers like my son and his family is to find a seller who cannot hold their house off the market and to offer a lower price than the house would have attracted a few months ago to offset its higher financing cost. The more that happens, the more the Fed will know its rate hikes are working.
Mark Flannery is a professor of finance at the University of Florida.
This article is republished from The Conversation under a Creative Commons license. Read the original article.
The views and opinions expressed in this commentary are solely those of the author.