Behind the curtain of the Fed’s latest rate hike

The Federal Reserve: the housing market’s boogeyman, or misunderstood anti-hero?

The Federal Reserve (the Fed) recently announced their biggest rate increase in decades, raising their target benchmark rate from 0.75%-1.00% to 1.5%-1.75%. This is the third rate increase this year, with more on the way, according to the June 2022 Federal Open Market Committee (FOMC) statement.

Real estate professionals, buyers, sellers and anyone else who has or will have a loan are dreading higher interest rates. So, why does the Fed insist on raising rates despite the negative public reaction?

The Fed’s main goals are to achieve:

• maximum employment; and
• annual inflation of around 2%.

However, in 2022, employment has taken a backseat to the Fed’s war against inflation. The Consumer Price Index (CPI) increased 8.6% over a year earlier as of May 2022. This includes annual price increases of:

• 107% for oil;
• 49% for gasoline;
• 16% for used vehicles;
• 13% for new vehicles; and
• 6% for shelter, according to the Bureau of Labor Statistics (BLS).

Importantly, the shelter measurement does not include home values, which have in fact posted a much larger annual increase. Rather, the shelter component measures the cost to rent. May 2022’s 6% annual increase in shelter costs was the highest increase experienced nationwide since 1991.

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When the Fed anticipates inflation rising higher than their 2%-3% benchmark, they raise the Federal Funds rate. This action induces a routine business recession, cooling off the market before it overheats and boils over.

But inflation has gotten out of control in 2022, and the Fed is playing catch up, raising rates quickly.

Pointing fingers in the housing market

Much like any other surgical procedure necessary to correct a problem, there will be some pain in the short term.

With the housing market already extremely tight, making it nigh on impossible for mortgaged homebuyers to compete, today’s rapidly rising interest rates are pushing out homebuyers and reducing home sales volume. Home prices are expected to follow in the second half of 2022.

But when stacked against high inflation, the short-term pain of higher interest rates is necessary to secure the long-term health of the housing market. Further, though high home values are not captured in the inflation rate, today’s interest rate action will also act to cool those down, returning the housing market to earth before it pops.

To reach their 2% inflation goal, the Fed anticipates several more rate increases in the coming months. Members of the Fed — who have full control over the target Federal Funds rate — expect their benchmark rate to peak around 3.5%-4.0% in 2023, falling back in 2024, according to the June 2022 Economic Projections.

However, mortgage interest rates will fall back sooner than short-term rates. The reason: mortgage rates are ultimately controlled by the bond market, which attempts to anticipate the results of current Fed actions. Thus, when it’s clear the Fed has gotten control over inflation sufficiently to be able to reach the Fed’s 2% target, the bond market reaction will become a decrease in all long-term bond rates.

When short-term rates rise, investment opportunities become less attractive, which drives investors into the bond market to park their cash until the economy rebounds. Higher bond market demand causes long-term bond rates to drop. Like a seesaw, when the Fed fights inflation, short-term rates rise and long term rates start to drop. When the long-term rates decline, mortgage rates begin to fall, all while the short-term rates are rising to reduce inflation.

For example, in 2022, lenders — along with members of the mortgage-backed bond (MBB) market — have been padding their risk premiums by demanding a wider spread between the 30-year fixed rate mortgage (FRM) rate and the risk-free 10-year Treasury Note (the standard corresponding long-term rate). Historically, this spread is around 1.5 percentage points. In June 2022, it has increased to over 2.5 percentage points.

By increasing the spread, the bond market is pushing FRM rates even higher. Investors are demanding higher rates for MBBs as a shield against future increased inflation, but also in expectation of losses from mortgage defaults which will arrive with the recession.

In other words, today’s high mortgage rates are not due directly to the Fed’s actions. But we can still expect some consequences — and prepare for what’s ahead.

Today’s higher interest rates are causing a noticeable ripple across the housing market. California home sales volume has already begun to slow, 10% below a year earlier as of April 2022. Sellers are increasingly cutting prices across most of California, according to Redfin. Once bankruptcies and job losses rise, the ripple will become a tidal wave.

The coming recession doesn’t have to be a career killer: learn how to stay ahead of the next recession and maintain income during the down market ahead.

Real estate professionals — do you believe the Fed’s actions will trigger a recession in the real estate market? Share your expectations for the months ahead in the comments below.