Parsing Fedspeak to See How High Rates Will Go
The trillion dollar question in real estate and banking at the moment is how high will interest rates go. One year ago in November 2021, the average 30-year fixed mortgage rate nationwide was still a hair under 3.00%, a nearly unprecedented historical low. According to BankRate.com, the average rate today is 7.32%, which needless to say is a huge jump in just 12 months and represents about $900/month extra in mortgage payments on the average sized loan. Prime Rate, which many banks price commercial loans upon, was 3.25% a year ago; today it is 7.00% with an expectation that it will rise to 7.50% or even higher by the end of the year.
In response to higher interest rates (among other variables), the real estate market is grinding to a halt. According to Hugh Son of CNBC, Wells Fargo recently reported 18,000 loans in its residential pipeline, which is down a staggering 90% compared to one year ago. Banks like Wells Fargo and various mortgage brokers have already made layoffs in their residential lending departments with more layoffs likely to come. Many mortgage broker companies will not even survive this period of high rates and low volume; indeed, some have already folded.
So how high will rates go? In 1981, the 30-year fixed mortgage rate peaked at over 18%. It didn't drop back to the single digits until 1986 and didn’t drop below 6.00% until 2003! Statements made by various Federal Reserve officials including Fed Chairman Jerome Powell may hold the key, and these various officials have been particularly chatty of late.
How the Federal Reserve Determines Interest Rates
I wrote a lot about the function of the Federal Reserve in February, so I won’t dwell on it much here other than to refer people who want to read more back to those earlier articles including the relationship between the monthly jobs report and interest rates. In short, the Fed has a dual mandate to promote full employment and an inflation rate around 2.00%. Since employment has been so strong and inflation is running red hot, the Fed has been using the primary tool in its toolkit, interest rates, to try to reign in said inflation even it if means damaging the overall economy including the labor market.
There are seven board members of the Federal Reserve Board of Governors and 12 regional presidents, although only five of these presidents vote for monetary policy; votes are determined on a rotating yearly basis with the New York Fed President always getting a vote along with the seven board members of the Board of Governors. These are the people that set monetary policy and they are nominated by the president for staggered 14-year terms (!).
What Fed Officials are Saying Now
The most important voice in the room at these Fed meetings is that of Federal Reserve Chairman Jerome Powell. This is a little bit beyond the scope of this article, but my opinion is that the Fed missed badly in 2021 by assuming inflation was going to be transitory and they kept interest rates too low for too long, and now they are trying to overcorrect by smashing inflation before it gets even more out of hand. But I believe prices are already coming down and the data on housing, which makes up over 1/3 of the key inflation statistic, will also soon show declines, it is just delayed by several months. So the Fed is continuing to hike rates excessively even though inflation is already starting to decelerate and will eventually normalize.
Earlier this week, the Fed raised interest rates another 75 basis points (for all intents and purposes, this means 0.75%). Chairman Powell, who has been extremely hawkish on inflation over the past few months, had this to say during a Wednesday press conference:
Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.
Today, the FOMC raised our policy interest rate by 75 basis points, and we continue to anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent.
He went on to say:
Reducing inflation is likely to require a sustained period of below-trend growth and some softening of labor market conditions. Restoring pricestability is essential to set the stage for achieving maximum employment and stable prices in the longer run. The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done…
…we still think there's a need for ongoing rate increases and we have some ground left to cover here and cover it we will.
In other words, the beatings will continue until morale improves. You can read the full transcript of Chairman Powell’s press conference here, if you are so interested.
A Break in the Ranks?
As noted above, there are seven members of the Fed’s Board of Governors and 15 regional presidents. The vote this week to raise rates by 0.75% was unanimous, as these votes often are. But several of the regional Fed presidents have started to speak out and lodge warnings that the Fed should be careful not to overdo it. For example, the Federal Reserve Vice Chair, Lael Brainard, had this to say recently:
We have tightened policies strongly to bring inflation down and…we're starting to see the effect on some sectors, but it's going to take some time for that cumulative tightening to transmit throughout the economy and for inflation to come down.
In other words, Brainard is acknowledging that the previous rate hikes the Fed has made are starting to have an effect and that inflation may be on the way down. Chicago Fed President Charlie Evans went even a step further, saying, “Overshooting is costly too and there's a great uncertainty about how restrictive policy must actually become.” Kansas City Fed President Esther George said in October, “Moving too fast can disrupt financial markets in a way... that can ultimately be self-defeating,” and, “The pace at which that path unfolds will need to be carefully balanced.”
So What Comes Next
Although Chairman Powell remains the strongest and most consistent voice in favor of continually raising rates, there seems to have been a slight pivot over the past three weeks where a softening of this policy is at least being implied thanks in large part to the comments by these other Fed officials. After an extremely rocky year, the stock market is up about 7% since the middle of October, which has been a nice albeit modest rebound for investors after heavy losses throughout the year so far.
The key number the Fed is going to be watching like a hawk is the monthly CPI inflation report. October’s CPI report is set to be released this coming Thursday at 8:30 am. Expect fireworks in the market either positively or negatively based on the results. If inflation is still north of 8.00%, expect pain the market as that will give support to the Fed to continue with an aggressive hiking strategy. If inflation starts to show signs of deceleration, though, I predict that markets will surge because it will give hope that interest rates might stabilize and the continual hikes we have seen for the past six months might ease. I believe we will soon see that deceleration.
That being said, most economists seem to believe the Fed will raise by another 0.50% at least once before the end of the year and if the inflation numbers are bad that could mean a hike of 0.75% instead or even more than one hike. That means more pain for borrowers and a further slowing of an already paralyzed real estate market. Stay tuned and buckle up.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank.
Good work Ben, I always forward to my two sons, very educational. Mark