What Today’s Economy Means for Homebuyers: How Interest Rates and Inflation Affect Purchasing Power
In the early days of the the coronavirus pandemic, our nation’s economy experienced a swift financial downturn. To minimize the damage, the Federal Reserve quickly stepped in and took action to stimulate and protect the economy. In March 2020, the Fed reduced the federal funds rate to 0% and also started purchasing massive amounts of Treasury bills and mortgage-backed securities (MBS). Fortunately, the Fed’s plan worked, helping keep mortgage rates at historic lows, fueling consumer demand, and propelling the economy to grow at its fastest pace since the 1980s. But other factors, such as a tight labor market, rising energy prices, and supply chain disruptions caused inflation to soar to its highest levels in 30 years. Since the economy no longer needed the extra stimulus — and, in fact, continuing it could do more harm than good — the Fed began reducing its bond purchases last November. And their next step will likely be to raise interest rates several times this year. So, how does all of this impact you as a consumer? Here’s what you need to know about how the economy, inflation, and interest rates are tied, and most importantly, how it affects your ability to purchase or refinance your home.
The Basics: Understanding Inflation
The basic definition of inflation is an increase in prices, leading to a reduction in purchasing power. This means you can’t buy as much with your money as you could previously. Inflation generally goes up in a strong economy, when people have disposable income and demand matches or exceeds supply. Conversely, inflation decreases when the economy is uncertain and people are spending less money. In a stable economy, wages rise to match inflation, so that higher costs are still manageable and people can still keep the economy moving by making purchases and circulating cash.
When Inflation Rises, So Do Rates
The Federal Reserve is charged with balancing inflation, supporting low unemployment and stable prices, and keeping the economy on track. One way they do this is by controlling short-term interest rates, which is determined by the fed funds rate.
What is the Fed Funds Rate?
The federal funds rate is the rate at which banks can borrow money from each other overnight to maintain their cash reserve requirements (that is, the amount of cash they must have on hand each night). It has a significant impact on the broader economy and affects things like inflation, credit cards, auto loans, and more.
When unemployment is high and inflation is low, the Fed will lower interest rates in an effort to stimulate the economy. Conversely, when unemployment is low and inflation is heating up — as it is now — the Fed will raise interest rates in hopes of deterring consumer spending and keeping inflation in check. As such, higher rates encourage people to save their money, as it will earn better interest; at the same time, it becomes more expensive to borrow money.
How the Fed Affects Mortgage Rates
When the Fed raises rates, does that mean mortgage rates will automatically go up? Not necessarily.
Mortgage rates are influenced by several market forces, including inflation, economic growth, the bond market, and housing supply and demand. The Fed does not directly set mortgage rates, but it does influence them. If the federal funds rate goes up for the aforementioned reasons, mortgage rates may follow suit accordingly, but not always. In short, mortgage rates and the fed funds rate move independently of each other, but often in the same direction.
Here’s an example of how the fed funds rate and the 30-year fixed mortgage rate have differed over the past 20 years.
Source: FRED, Board of Governors of the Federal Reserve System
Good to Know: The 10-year Treasury yield has been the most likely indicator of where mortgage rates are headed. (The one exception is HELOC rates, which are tied to the U.S. prime rate, and therefore, the fed funds rate.)
How Higher Rates Impact You
So, back to the overarching question: If mortgage rates do increase, how does it affect your ability to purchase or refinance your home? As interest rates rise, it will reduce your buying power, meaning you won’t be able to buy the same items and services for the same cost as you once could.
Say you have a budget of $1,600 for your monthly mortgage payment (principal and interest only). If interest rates rise just 1%, you’ll be paying nearly $1,800 per month for borrowing the same amount of money. Or if you want to stay at a budget of $1,600, it means you have to settle for a lower purchase price.
Of course, we can’t predict what will happen to mortgage rates over the course of 2022. What we do know is that mortgage interest rates are still very low, and with the Fed planning to increase the fed funds rate several times this year, mortgage rates could also go up. If you’ve been on the fence about buying or refinancing a home this year, be sure to factor in the potential for higher mortgage rates and that waiting too long could limit your buying power.