Lake County News, CA – Disheartened Buyers Show Why the Fed’s Unprecedented Inflation Fight Is Beginning to Succeed

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Home sales slow as Fed hikes rates. AP Photo/John Raoux

I’ve studied finance and financial markets since the 1970s, and I’ve never seen the Federal Reserve’s monetary policy get as much media coverage as it did last year.

And with good reason. What the Fed is doing has profound implications for businesses, consumers and the US economy, especially now that the US central bank is trying to rein in the fastest rise in consumer prices in decades. In short, the Fed raises interest rates in the hope that it will slow the economy enough to bring inflation down.

The housing market is the sector most influenced by changes in interest rates and, as such, it is a key indicator of the success of the Fed’s plans. To understand why, I need only consider my son’s experience — or the many other Americans looking for a new home in an era of rising interest rates.

What the Fed is doing

First, a little background.

The Federal Reserve is raising interest rates at the fastest rate in its 108-year history as part of its fight against inflation. Today’s big policy moves are necessary in part because the Fed and many others were slow to figure out what was causing inflation to rise.

In the fall of 2021, as the pace of inflation accelerated past 4%, double the Fed’s target rate, the prevailing view at the central bank and elsewhere was that it reflected temporary disruptions after two years of COVID-19 related slowdowns. The assumption was that inflation would automatically decline as supply chains developed.

Unfortunately, that assumption turned out to be wrong because it failed to recognize how much government COVID-19 relief spending had boosted what economists call “aggregate demand” — in other words, total demand. goods and services produced in an economy. In other words, consumer spending stimulated by government assistance has created strong demand across the economy.

Thus, consumer prices continued to accelerate. Russia’s war in Ukraine has compounded the problem, including by driving up global food and energy prices. In June 2022, inflation reached 9.1%, the fastest pace since 1981.

Although the Fed can’t do much about war or other supply chain issues, it can respond to aggregate domestic demand. This is where higher interest rates come into play.

Higher borrowing costs are stifling consumer demand for homes, cars and other goods and services that typically require a loan, while businesses cut investment in factories and hiring, which should dampen headline inflation.

The Fed began its latest tightening policy in March 2022 with a 0.25 percentage point increase in its target interest rate, which serves as a benchmark for other borrowing costs in the United States and around the world. Since then, the central bank has raised its policy rate twice – by 0.5 percentage point in May and 0.75 percentage point in June.

On July 27, the Fed is expected to raise the rate an additional 0.75 percentage points, although some observers predicted an unprecedented 1 point increase after the June consumer price report showed that inflation continued to accelerate.

Why the housing market matters

The trick to reducing inflation is to stifle aggregate demand enough to bring inflation under control without dragging the economy into recession. One of the main ways to see if this is happening is to look at housing, which has historically been particularly sensitive to rate changes and constitutes more than a quarter of total US wealth.

Because buying a house or apartment is such a large expense, almost all buyers have to borrow a fairly large portion of the purchase price. And just as record high mortgage costs in 2021 helped fuel a housing market boom by reducing the cost of servicing that debt, higher rates are raising the cost, discouraging home purchases.

The average rate for a 30-year mortgage hit 5.81% in June, the highest level since 2008 and up from less than 3% for most of 2021. The rate currently sits at 5 .54%. On a $200,000 mortgage, a rate of 5.54% translates to over $400 in additional interest costs each month compared to 3%.

Faced with such a surge, some house hunters – like my son – took a step back and wondered if now was a good time to buy.

Housing begins to stall

In other words, higher mortgage rates encourage individuals to invest less in housing. And the effect of lower demand doesn’t stop at home. When people buy a new home, they also tend to buy new furniture, lawn equipment, televisions, etc. And buying a second-hand home often means hiring contractors and others to remodel the kitchen or build a new closet in the kids’ room.

So if people are buying fewer houses, they are also buying fewer furniture, electronics, and lawnmowers, and needing less electricians and plumbers.

The drop in demand for all these goods and services should significantly dampen inflation. While it’s still too early to tell if this part of the Fed’s plan is working, we can already see the effects of rising mortgage rates in recent housing data.

In recent months, fewer new homes are being built, fewer existing homes are being sold, and homebuyers are moving away from signed deals at the fastest rate since the COVID-19 pandemic began.

At the same time, consumers and investors are beginning to anticipate lower inflationary pressures over the next year or so.

What this means for homebuyers

As the Fed prepares to raise benchmark rates again, what does this all mean for American consumers, and especially my son and others looking for a new home?

On the one hand, don’t expect long-term interest rates, including for mortgages, to rise much, and certainly not by the same amount as the Fed’s interest rate hike.

Investors tend to factor expected Fed policy changes into its market rates. So unless there’s a surprise from the Fed, like a full one-point hike, long-term rates shouldn’t change much. And they might even start falling soon, either because inflation is subdued or the US is slipping into recession.

And while it would be nice to know how tighter monetary policy – ​​that is, higher interest rates – will affect current stratospheric house prices, it’s 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 the sale rather than accept a lower price.

The challenge for potential buyers like my son and his family is to find a seller who can’t hold his house off the market and offer a lower price than the house would have attracted a few months ago to offset its cost. higher funding. The more this happens, the more the Fed will know that its rate hikes are working.The conversation

Mark Flannery, Professor of Finance, University of Florida

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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