Fed’s High Wire Inflation Fighting Effort Risks Triggering a Recessionary Fall

Imagine a high-wire act performed without a net.  That describes the Federal Reserve’s effort to curb inflation without crashing the economy.  Success will bring applause and relief; failure, a brief downturn, at best, with a prolonged recession the worst case outcome. 

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In a move telegraphed clearly and undeterred by the Crimea turmoil, the Federal Reserve increased  interest rates for the first time in four years, raising its benchmark rate by one-quarter- of percentage  point, from zero to a range of 0.25 percent to 0.5 percent, and indicating that additional rate hikes are coming. 

The policy shift affirmed the Fed’s concern about inflation and its determination to tamp it down.  But the move did not end the debate between analysts who thinks the rate increase is too small and comes too late to counter inflationary pressures, and those who contend that higher rates are unnecessary and will likely trigger a recession.  

Multiple factors – wage growth, supply chain interruptions, strong and sustained consumer spending and the Ukraine invasion among them – have rapidly pushed the annual inflation rate close to 8 percent, well above the Fed’s target rate of 2 percent, forcing policy makers to respond.  The Federal Open Market Committee (FOMC) indicated that it anticipates additional rate hikes at each of the six remaining meetings this year, pushing the Fed’s benchmark federal funds rate to close to 2 percent by year-end.  Fed Chair Jerome Powell indicated that he is open to rate hikes more aggressive than the quarter-point increments most analysts are predicting. 

“We are attentive to the risks of further upward pressure on inflation and inflation expectations,” he told reporters at a news conference following the FOMC meeting. “The committee is determined to take the measures necessary to restore price stability, he emphasized, adding, “The U.S. economy is very strong and well-positioned to handle tighter monetary policy.”

 

An Awful Position

“We might be on the cusp of the Fed raising rates at the same time there is a minus sign in front of GDP,” Peter Boockvar, chief investment officer of Bleakley Advisory Group, wrote in a note to clients. “What an awful position to be in, but until inflation falls sharply, they have no choice but to carry on.”

How the Fed’s balancing act plays out in the economy won’t be obvious for a while, but the recent and projected rate hikes have had an immediate impact on mortgage rates, which have climbed above four percent for the first time in three years.  The average rate on a 30-year fixed rate mortgage hit 4.72 percent at the end of March, with 5 percent likely and rates above that level possible, some analysts believe. 

“Rates have a small chance to top out before hitting 5% and a good chance of topping out before hitting 6%,” Matthew Graham, chief operating officer at Mortgage News Daily, told CNBC. “It is a rapidly moving target in this environment, where we legitimately and unexpectedly find ourselves needing to be concerned with inflation for the first time since the 1980s.”  

 

Sales Slowing

Home buyers, anticipating higher rates, have remained in the market, competing for scarce listings, but February existing home sales (reflecting closings before the Fed hiked rates) fell by more than 7 percent compared with January and were 2.4 percent below the year-ago level. 

Pending sales, which  fell for the fourth consecutive month, are now down 5.5 percent year-over year, and new home sales, which had slipped in January, fell again in February, falling by 6.2 percent year-over-year. 

Builder confidence levels reflect the gap between what builders see today (strong demand) and what they anticipate as higher rates take hold.  The current conditions component of the National Association of Home Builders confidence index (HMI) fell 3 percent in March, while the gauge measuring expectations for the next six months plunged by 10 points.

The Mortgage Bankers Association, (MBA), meanwhile, reports that purchase mortgage applications fell by 8 percent year-over-year in February while refi applications declined by nearly half, providing more evidence that housing was beginning to slow before the Fed hiked rates.  . 

 

Prices Still Rising

Home prices, however, have continued to defy economic gravity, as scarce inventories and what analysts term buyers’  ‘fear of missing out’  have largely offset rising rates and affordability pressures.  The Core Logic-Case-Shiller index of national home prices rose by 19.2 percent year-over-year, beating the 18.9  percent annual increase in December.  Rising prices and higher rates have pushed the monthly payment for a median-priced home almost 30 percent above  year-ago level, according to the MBA.

As rates and prices continue to rise, something has to give, and most analysts think it’s going to be home sales. Anticipating that mortgage rates  will remain in the 4.5 percent range this year, Lawrence Yun, chief economist for the National Association of Realtors, has slashed his forecast for 2022, now predicting that sales will decline by 6 percent to 8 percent– about double the dip he was predicting a few months ago.  

Danielle Hale, chief economist for Realtor.com is more optimistic about the market outlook, because she thinks buyers will find ways to cope with rising homeownership costs. “So far, buyer activity has been resilient,” she told CNBC, but she also acknowledged that “demand will be tested by an extraordinary year.”

Ian Shepherdson, chief economist and founder of Pantheon Macroeconomics, a research consulting firm, thinks demand will ultimately fail that test. In fact, he says the housing market is already “in the early stages of a substantial downshift in activity,” a prelude to “a steep decline” in home prices, possibly beginning this spring. 

Theoretically, reduced demand would ease inventory pressures and perhaps cool appreciation rates as well.  But declining demand and slower price gains could also discourage sellers from putting their homes on the market, , exacerbating the inventory problem rather than alleviating it.  As Shepherdson told Realtor.com,  “No one wants to be the last person trying to sell into a falling market.”