Inflation measures change in the price of consumer goods and services over a period of time. It also measures the dollar’s loss in purchasing power from year to year. Thus, when inflation increases 2% over the prior year, the dollar in your pocket is typically able to buy 2% fewer goods and services.

Beyond the obvious loss in purchasing power brought on by inflation, the impact on the housing market is substantial. To explain, a quick overview of how inflation is measured and controlled is needed.

Inflation, in the hands of the Fed

One of the Federal Reserve’s (the Fed’s) prime economic functions is to regulate inflation through the use of monetary policy. It does this by:

  • controlling the amount of money in circulation; and
  • inducing or discouraging banks to lend by acting to raise and lower the federal funds rate.

The reason? When too much or too little — or worse, negative — inflation occurs, the economy is thrown into disarray. The Fed considers a steady 2%-3% inflation rate to be a healthy target to keep the economy moving (without moving too quickly).

Inflation is measured by the consumer price index (CPI). Included in the CPI are:

  • food and beverages;
  • housing costs such as rent;
  • clothing;
  • transportation, including gasoline;
  • medical care;
  • recreation, including televisions, pets, sport equipment, etc.;
  • education and communication; and
  • other goods and services, like the cost of haircuts, funerals, etc.

Notably excluded from this list are home values.

Some of the goods used to measure the CPI are volatile — think of how often the price of gas fluctuates. This volatility throws off the usefulness of the CPI. That’s why the sticky price CPI exists:


The chart above shows the sticky price index (the blue line), which measures the inflation rates of more durable goods that are consumed and replaced frequently. This makes for a more gradual shift over time.

The chart also shows the effective federal funds rate (the red line), slightly different from the target federal funds rate set by the Fed. The Fed’s target rate is a range: 0.75%-1.0% as of March 2017. The Fed conducts open market activity to push the federal funds rate into their target range, though it sometimes will deviate from their target due to short-lived and extenuating economic conditions.

Inflation and interest rates have an intentionally similar relationship so it is fitting that they move in proximate unison. 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.

Editor’s note — Look no further back than the Millennium Boom and resulting market crash for a recent example of what happens when the economy overheats.

Conversely, when inflation falls during a recession, the Fed has the power to lower the federal funds rate, which in turn causes other interest rates to follow. This incentivizes banks to lend and increase the supply of money in circulation, helping churn the economy out of recession. Following the collapse of the Millennium Boom, the Fed dropped the federal funds rate down to essentially zero. They could not go lower unless they went negative, meaning the only way forward is up.

Future rates

The Fed projects a positive 1.8% inflation rate for 2017 and a 2% rate for 2018-2019. While this is barely reaching their inflation goals, members of the Fed still claim 2017 is the appropriate time for several rate increases. Are they being too quick to raise rates?

Perhaps. But the Fed is faced with a conundrum: risk raising rates too soon and stunt organic growth, or be left with no functional tools to decrease rates when the next recession sets in?

The Fed has hedged its bets on rapid economic growth, signified by today’s low unemployment rate — 4.5% in March 2017, the lowest since before the recession — and expanding economy.

Fed rates and mortgage rates

This chart shows the federal funds rate (the red line) next to the U.S. average 30-year fixed rate mortgage (FRM) rate (the green line):


There is some wiggle room, but since 1971, the 30-year FRM rate has averaged 2.9% above the federal funds rate. As of March 2017, the 30-year FRM rate averaged 3.4% above the federal funds rate.

When the federal funds rate rises or falls, FRM rates adjust in similar fashion. Other factors, like bond market sentiment and foreign investment, also push and pull on mortgage rates. But FRM rates are intrinsically tied to the federal funds rate and to the Fed’s constant battle to combat and maintain inflation.

It all comes back to demand

To recap, inflation impacts the housing market through the Fed’s intervention to influence interest rates. Mortgage rate movement is the number one influencer of buyer purchasing power.

Buyer purchasing power is a buyer’s ability to purchase property at currently available interest rates. Buyers with cash on hand don’t have to worry so much about interest rates, thus their purchasing power stays relatively constant relative to their income and savings. However, this is the exception as approximately 80% of buyers need some form of mortgage financing to fund their purchase of a property.

Thus, for the vast majority of buyers, when mortgage rates rise, buyer purchasing power falls. When mortgage rates fall, buyer purchasing power increases.

In 2017, mortgage rates are on their way up and buyer purchasing power is falling. This is compounded by the fact that California home prices continue to rise well beyond the rate of buyer incomes.

As homes and interest rates soar beyond the reach of most hopeful buyers, demand begins to slide. First-time homebuyers throw in the towel as they can no longer qualify to buy the home they want. Sellers become skittish and decide to stay put since they don’t want to trade their low mortgage rate for a higher one and thus inventory shrinks. Like a dying star, the housing market soon implodes, only to cool off and make way for the next virtuous cycle.

This is the point we find ourselves in 2017. Home prices have increased continuously since 2012, though the trajectory of the rise has scaled back in the past couple of years. Mortgage rates have begun to creep up and will continue to do so in the foreseeable future. Inventory is shrinking in the low tier and collecting in the high tier, where few can qualify to buy.

Next up is the reactionary price drop, anticipated in late-2017. It typically takes 9-12 months for prices to react to higher mortgage rates, which started to increase significantly in November 2016.

It’s all part of the larger economic cycle, and — like it or not — the Fed is in the driver’s seat.