12/21/2021
Following yet another month of record-setting inflation, the Federal Reserve (the Fed) has announced during their December 2021 meeting a quicker end to their economic support than previously determined.
The Fed’s goals are to maintain:
stable prices — or a moderate level of inflation;
maximum employment; and
moderate long-term interest rates.
To achieve these goals, the Fed uses a number of tools, including their benchmark Federal Funds Rate. During times of economic distress, the Fed also makes bond market purchases.
Interest rates on long-term products, such as 30-year fixed rate mortgages (FRMs), reflect bond market investor perceptions about the level of success the Fed will achieve fighting inflation. When the Fed’s inflation fight becomes aggressive, the long-term bond rates decline as investors pile back into bonds. In contrast, when the Fed allows inflation to rise beyond its target rate, investors shy away from bonds, and these bond rates rise.
In other words, when bond prices are rising (as during 2020-2021), interest rates tend to fall. When bond prices fall, interest rates rise; an inverse relationship.
Beginning in March 2020, the Fed began buying $120 billion per month in bond market purchases, including mortgage-backed bonds (MBBs), thereby reducing the supply of MBBs. Axiomatically, a reduced bond supply means higher prices — and lower yields, reflected in lower interest rates. While many of the factors influencing today’s high inflation are transitory — meaning, pandemic-induced and likely to ease off with a return to stable supply-side economics — the Fed’s MBB purchases now seem excessive for prices, and even dangerous.
In November 2021, the Fed announced their plan to begin tapering MBB purchases by $15 billion a month, including a $5 billion-per-month reduction in MBBs.
However, inflation continues to rise rapidly. The latest report shows the year-over-year consumer price index (CPI) up 6.8%, the highest level of U.S. inflation experienced since 1982, according to the Bureau of Labor Statistics (BLS).
Thus, the Fed is being forced to reign in their bond market purchases more quickly, from $15 billion less to $30 billion less per month. At this pace, the Fed’s bond buying program will wind down completely by March 2021.
Bond taper = higher interest rates
As the Fed reduces and eventually ceases its MBB purchases, prices will fall. In turn, interest rates on mortgage products will inevitably rise.
Further, the Fed expects to increase their benchmark rate three times in 2022, from today’s zero to 0.75%-1.0%, according to Fed’s latest economic projections. Previously, they had assured the public they would not increase the Federal Funds Rate until 2023.
The implications for real estate are clear.
Mortgage interest rates have already begun a gradual increase in 2021, with the average 30-year FRM rate increasing from a low of 2.65% in January 2021 to the current average of 3.12%. Today’s higher interest rates mean less principal available to homebuyers with the same mortgage payment.
The average FRM rate increase throughout 2021 alone has seen buyer purchasing power reduced by 5%. In other words, a homebuyer with the same income and savings at the beginning of 2021 now qualifies for 5% less mortgage principal due to interest rate increases alone.
Buyer purchasing power exerts a pull on home prices. In fact, the rapid rise in asset prices, including home prices, is forefront in the Fed’s decision to allow interest rates to rise. Here in California, the average annual home price increase ranges from 19% in the low tier to 22% in the high tier as of September 2021. While significant, this price increase has eased somewhat from mid-year.
Expect home prices to continue to fall back in 2022. On top of the Fed’s easing off the gas pedal by allowing interest rates to rise, home prices are also losing momentum due to a growing inventory of homes for sale, fueled by the end of the foreclosure moratorium and forbearance programs. This will be good news for homebuyers, who have spent the last 18 months struggling to gain a foothold amidst months of high competition for an historically low inventory of homes.
