Coldwell Banker Premier Realty Blog

Scenario's Following a Rate Hike

Leaving the zero-bound makes lots of questions
Posted: November 23, 2015 by John McClelland

With the December Federal Open Market Committee meeting drawing near, it is useful to revisit some of the themes that may play out and offer a little background on the Fed policy rate, mortgage rates, housing price and commercial property value sensitivity to shifting rates.

Bloomberg notes that Federal Reserve (The Fed) policy makers inserted language in the October statement that indicated that it might be time to raise the benchmark lending rate in December, reiterating that these increases would be gradual. Now it is not as if the Fed hasn’t cried wolf at least a couple of times, with some members implying that the Fed may move the rate, only to have Fed Chairwomen Yellen deliver public statements that the Fed would not yet do so, based on its data dependent analysis of the economy and inflation. However, eventually the Fed is likely to move off of these extreme lows and many question, what will this precipitate throughout the housing and commercial property markets?

Firstly, nobody knows with certainty, however a gradual increase will most likely offer the markets an opportunity to adjust with some order. The Fed is isn’t fighting inflation like it had to do in the 1980’s and shock the economy out of in inflationary nightmare. Since the financial crisis, the Fed has been doing the reverse, fearing deflation and appears to have hoped for a bit higher inflation than was being registered by the CPI measures. Now before we can get into the details of this subject, we need a little background.

The primary policy rate used by the Fed is the Federal Funds rate, which is a very short-term rate and is the interest rate that depository institutions trade balances held at the Federal Reserve, often on an overnight basis. The Fed does not directly change mortgage rates, auto loan rates or consumer loan rates. The Fed can influence these rates, but supply and demand and the pricing of risk (traditional market forces) and the role of expectations of inflation and government guarantees remain the mechanisms for which these rates shift. This is made more obvious when one looks at mortgage interest rates and the federal funds rate. Federal funds rates have been flat but mortgage rates move all the time. A bump in the Federal Funds rate does influence the market in a couple of ways; one, it increases the overnight borrowing costs, which may cycle through other debt instruments, albeit not step-for-step, and secondly, it signals to the public that The Fed believes the economic signals are strong enough to move off of the zero bound (unless one believes The Fed hasn’t done a good job). So in one sense the policy move is a response to improved economic conditions.

Why do we care about all this? In our minds, we ask how sensitive is housing demand to mortgage rates? Could a rate increase hijack the housing recovery we have been in? (Zafar, 2014) study this problem using survey data and their findings suggest that “housing demand is strongly affected by fundamentals (household wealth and income) and also the quantity of available financing (especially for first-time home buyers). The price of available financing (that is, the mortgage rate) may play a less important role than commonly thought, although we emphasize that our stylized setting omits certain factors, such as payment-to-income constraints, that may in reality affect households’ ability to qualify for loans.” 

So, while rates do matter, fundamentals may matter more. That doesn’t mean homebuyers won’t freeze up momentarily if rates spike, but a gradual ratcheting up should be tolerable if interest rate increases are mild as long as fundamentals like job growth and other wealth creators continue to improve. Further, users of new fixed-rate instruments are likely to feel less of an impact than variable financing users or existing variable financing users, which may see an increase from what is essentially an artificially low rate (individuals with these should be careful to check when rates are scheduled to change). Another factor coming from the supply side stems from mortgage availability. The Fed policy has helped mortgages become more affordable, but not necessarily more available.

Zooming out at the history of 30-year mortgages, it’s still obvious that mortgage payments are likely to represent a smaller proportion of income than many prior years. Finally, consumers have a lot of longer-term debt but are being paid a pittance on deposit balances. Higher interest rates may in fact help some consumers, particularly retirees that have significant cash and certificate of deposit holdings. So, our view is that an increase in the Federal Funds rate is unlikely to alter the housing market directly and our concern would be from issues arising from a distorted fixed-income market, which offers a less reliable guide as a market signal or exogenous events that could influence the economy from a different channel, such as a large sovereign debt default or natural event. 

Zafar, A. F. (2014). The Sensitivity of Housing Demand to Financing Conditions: Evidence from a Survey. New York: Federal Reserve Bank of New York Staff Reports, no. 702.

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