What does the Fed’s rate hike mean for housing?

(This article was originally published on NAHB.org by chief economist Robert Dietz, and edited for content and style.)

Federal ReserveWashington, DC – To combat ongoing inflation, the Federal Reserve has committed to significantly cooling demand. This approach reflects a non-monetary policy that has failed to address the underlying supply-side challenges driving inflation. The Federal Reserve has no policy tools to create these supply-side solutions, so it must rely on demand-side securities to curb inflation by slowing economic growth.

As a result, at the end of its June meeting, the Federal Reserve raised its target rate for the federal funds by 75 basis points, raising that target to a cap of 1.75%. This is the largest fund rate increase since 1994 and is a clear response to May’s high inflation figures. In addition, the Federal Reserve’s forward-looking forecasts on a median participant base point to an additional 205 basis point tightening through 2023. Without convincing evidence of inflation moderation, the Federal Reserve is likely to continue raising its target rate by 50 basis points at each meeting. points or more. The Federal Reserve’s target is 2% inflation.

The Federal Reserve’s June statement also confirmed its existing plan to shrink its balance sheet, including a net reduction of $35 billion in mortgage-backed securities per month when fully phased in. The lack of change for the balance sheet reduction plan is a positive element of the news for housing, as there was a risk of a planned faster pace, which would cause mortgage rates to rise further.

Given the signs of slowing economic activity, including six straight months of declines in homebuilder sentiment, there is a clear risk that by lagging the curve, the Federal Reserve will overshoot tightening and trigger a recession as it moves into recession. fight inflation. This would not be the soft landing the Federal Reserve is trying to orchestrate. The NAHB’s economic forecast now includes a recession in 2023 as financial conditions tighten. Chairman Powell noted in his press conference that housing market conditions are slowing due to higher mortgage rates.

The Federal Reserve notes that inflation remains high, citing, among other things, the war in Ukraine and problems with the global supply chain. Their revised economic projections see slowing economic growth, with a GDP forecast for 2023 of 1.7%. This will be very difficult to achieve. According to the Federal Reserve’s unemployment forecast, that percentage will rise to 4.1% through 2024. So even under this optimistic outlook, this increase in unemployment would qualify as a growth recession.

As this economic slowdown unfolds, the Federal Reserve’s projections indicate that inflation will decline. Using the core PCE measure, the Federal Reserve sees a rate of 4.3% for 2022, then 2.7% in 2023 and falling to 2.3% in 2024. This too will be difficult to achieve given the delayed impact on the inflation of rising house rents, which show up in inflation measurements on a delayed basis when leases are renewed. This sheltered effect on inflation is also a reminder that a tightening of interest rates can affect supply, not just demand. Higher rents are caused by a lack of housing supply. And a higher interest rate makes it difficult to finance the development of the extra housing supply.

It is important to note that there is no direct relationship between rate hikes by the federal funds and changes in long-term interest rates. During the latest tightening cycle, the Federal Funds target rate rose from November 2015 (at a top rate of just 0.25%) to November 2018 (2.5%), up 225 basis points. During this time, however, mortgage rates rose by a comparatively smaller amount, from around 3.9% to just under 4.9%.

Earlier, the Federal Reserve noted that inflation is high due to “supply and demand imbalances related to the pandemic, higher energy prices and broader price pressures”. While this verbiage may include policy failures that have affected aggregate supply and demand, I think the Federal Reserve should explicitly recognize the role fiscal, trade and regulatory policies play in the economy and inflation.

Given today’s forecasts, we reiterate our policy recommendation regarding any possibility of a soft landing. It is clear that elevated inflation rates require a normalization of monetary policy, especially as the economy moves beyond covid-related effects. However, as part of this adjustment, fiscal and regulatory requirements should complement monetary policy. Yet many of these measures are simply out of the Fed’s control.

For example, the higher inflation in housing is due to a lack of rental and sales inventory and cost increases for building materials, lots and labour. Higher interest rates will not produce more wood. A smaller balance sheet will not increase the production of devices and materials. In short, while the Federal Reserve can cool the demand side of the economy (by reducing inflation and growth), additional production on the supply side is needed to curb the cost growth we see in housing and other sectors of the economy. economy. In particular, efficient regulatory policies can help achieve this goal and fight inflation.

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