Higher Rates Not Likely to Derail Housing Market

The Fed’s Impact on Housing

The Federal Reserve released its minutes of its latest Federal Open Market Committee (FOMC) meeting that took place on July 29th to July 30th. In addition, Fed Chairwoman Janet Yellen gave a speech regarding labor markets in Jackson Hole, Wyoming later in the week. As a reminder, the Federal Reserve has a dual mandate. Essentially, it is to keep inflation tame and maximize employment. We discuss the important points of each event and the future impact on the real estate market.

Federal Reserve economic view

The minutes provide insight into the Fed’s thinking on the economy and monetary policy going forward. This has important implications for the housing market. The central bank noted economic growth has improved. Indeed, it rebounded sharply to a 4% annual growth rate after a weak first quarter in which it contracted by 2.1%, according to the Bureau of Economic Analysis (BEA).  Many economists attributed the weak first quarter to the harsh winter weather experienced in many states. We are inclined to agree, and the latest figures support this argument.

The strength of the labor market will be a key consideration for when the Fed decides to raise short-term interest rates. Towards that end, the FOMC cited improved labor market conditions, including a declining unemployment rate. Household spending is rising moderately and business fixed investment is advancing. These are important for economic growth, and the Fed believes the economy is strong enough to support an improvement in the labor market. Still, there remains significant slack and the Fed believes the workforce is being underutilized at this time. Chairwoman Yellen stated there are an array of important labor statistics. Although the unemployment rate is falling, reaching 6.2%, the labor market has not fully recovered.

The Fed has a Labor Market Index comprised of 19 indicators. Using this as a guide, the unemployment rate overstates the improvement. The speech dampened expectations that the Fed was contemplating raising rates anytime soon. The Federal Reserve continued to reduce the pace of its asset purchase program by $5 billion for mortgage-backed and Treasury securities, down to $10 billion and $15 billion a month, respectively. The committee still wishes to maintain downward pressure on longer-term rates, including those on mortgages. It will complete this program before it contemplates raising short-term interest rates. In fact, the Fed still plans to keep the current near zero percent interest rate policy for a “considerable time” after the asset purchase program ends. We break the impact of future interest rate decisions into mortgage rates and housing prices. The former is discussed quite a bit in the media, but the latter is less understood.

Interest Rates

Traditionally, the Federal Reserve controls short-term interest rates. It does this largely through setting the federal funds rate. This is the rate banks charge each other for short-term loans, which are usually overnight. The Fed targets a rate and achieves it through either buying or selling securities. Many expect the Fed to raise interest rates in 2015, although the latter half of next year would seem more likely given the minutes and Yellen’s speech. The fed funds rate has been held at 0% to 0.25% since 2008 in an aggressive effort to stimulate the economy from the throes of the Great Recession. In addition, the Fed will likely raise the discount rate at the same time. This is the interest rate it charges other banks. Typically, the central bank does not lend to these other institutions, but it did so when the system ceased to function and credit dried up during the aforementioned time frame.

The discount rate affects the prime rate, or the rate banks charge its best customers. This, in turn, impacts short-term, variable rates. These include home equity lines of credit and adjustable rate mortgages. Those contemplating taking out these types of loans should be aware that rates are likely to go up, probably sometime in 2015 barring an unexpected event or downturn in economic growth. If you already have such a loan, converting to a fixed rate at this time seems prudent. During the extraordinary events of the Great Recession, the Fed attempted to pump money into the system and keep long-term borrowing costs low by purchasing Treasury and mortgage-backed securities.

This is known as quantitative easing (QE), and the Federal Reserve is slowing its monthly purchase rate. Its goal is to cease the program in October. The program has been credited with holding down long-term interest rates, including those on mortgages. When the Fed initially announced a slowdown to purchases in December 2013, interest rates on ten year Treasury bonds rose steadily, reaching 3% at year-end from 1.9% at the start of 2013. Still, despite the Fed continuing to cut back its purchases, ten-year rates have fallen this year, to 2.41%. This suggests larger forces at work, including a flight to quality, particularly given the international events, moderate inflation, and the Fed’s measured approach to slowing purchases.

Home Prices

Higher interest rates may not be negative for those shopping for a new home. Many focus on the higher mortgage payments that result from higher interest rates. Rates are going to rise in the future due to a stronger economy, this is positive. It should give people more confidence to buy a home. In turn, this creates a positive cycle. The home market has traditionally given a boost to the overall economy as those moving into a newly purchased home spend money on items such as furnishings and construction. There are also benefits to sellers resulting from a stronger economy. This should create more buyers with more confident. Demand should not be dampened too much as rates will still be low by historical standards, even if it is higher than during the extraordinary times of economic distress.

Conclusion

The dark days of the Great Recession are behind us. There is still an opportunity to obtain an attractive mortgage, although it may be an opportune time to lock in a fixed rate given short-term rates will rise, probably sometime next year.