Chief Economist Eugenio J. Alemán discusses current economic conditions.
The Federal Reserve Bank (Fed), the central bank of the United States, has a difficult task ahead. The most important objectives of the Fed are: “maximum employment, stable prices, and moderate long-term interest rates in the United States.” In order to do that, the Fed has, fundamentally, one tool: it determines a short-term interest rate called the federal funds rate. The federal funds rate is the rate at which commercial banks borrow and lend their excess reserves to each other over overnight.
The Federal Reserve does this by engaging in open market operations. If the Fed sells bonds into the market, then bond buyers buy these bonds, and the Fed takes liquidity out of the financial sector. That is, the Fed ‘dries’ the market of cash and thus interest rates increase. If the Fed buys bonds from the market, the opposite happens. When the Fed buys bonds from the market, it injects new cash and new liquidity into the financial markets and thus interest rates go down.
The Fed started to increase interest rates in March of this year with a 25 basis point increase and followed in May with another, but this time larger, 50 bps increase. In normal circumstances it would take 6 to 12 months for the effects of monetary policy to affect the US economy. But the Fed is not done yet. The expectation is that the Fed is going to continue to tighten monetary policy, e.g., increase interest rates, during its monetary policy meetings in June, July, and September. For each one of these meetings, they are expected to increase interest rates by 50 bps. The Fed has a meeting in early November, but it seldom increases interest rates so close to an election. Thus, it is also expected that the Fed will increase interest rates further during its December meeting.
If these expectations of Fed tightening come to fruition, this would mean that the federal funds rate will be in a range of 2.75 to 3.00% by the end of the year. Economists today consider a 2.25% to 2.50% federal funds rate level a ‘neutral’ federal funds rate. That is, it does not add or subtract from economic activity. Thus, by the end of the year, if current expectations about Fed tightening hold true, the federal funds rate will be binding, that is, it will be at a level that has the potential for taking the economy into recession.
Will the Fed take the federal funds rate over the neutral rate?
This will depend on the incoming data as we approach the December monetary meeting time frame. That is, it will depend on the behavior of inflation from now until December. If inflation remains on a downward trend for the rest of the year on a year-over-year basis, then the Fed will probably not have to increase interest rates in December, and it will remain at a level of 2.25 to 2.50%.
But let’s take a step back. All this discussion is predicated on the assumption that what the Fed has done so far is not able to slow down the growth rate of the economy in order to tame inflation.
Some of the data we are getting, especially on the US housing market, is pointing to a sector that is starting to feel the pain created by higher interest rates. The strong reaction from mortgage interest rates to the increase in the fed funds rate since March seems to have started to bite into the strength of the housing market. Still, the data this week pointed to strong home price appreciation, so more work/time is needed to see the full effects of current tightening. Sales of existing family homes at the lower end of the home price spectrum across the country showed a strong decline on a year-earlier basis in April while housing starts of single-family homes showed a second monthly decline on a seasonally adjusted basis in April even thought it was still higher versus a year earlier. Meanwhile, multi-family housing starts continued to expand, both on a month-over-month basis as well as versus last year.
Today, the median home price in the US is over $400,000, more than double the prices seen at the bottom of the housing bubble over a decade ago. Some regions have experienced a more than 30% year-over-year price increase. The pandemic seemed to have increased the demand for housing in some regions as people moved to states with lower home prices as more firms implemented ‘work-from-home’ strategies to minimize the effects of the pandemic in the work force. Furthermore, some firms then moved to keep those strategies to try to retain talented workers interested in continuing to work from home.
Housing starts were slow to recover coming out of the Great Recession and have lagged housing demand since, a combination that has added pressure to the supply of available homes, pushing home prices up further. However, this trend in home price appreciation is expected to reverse as mortgage interest rates continue to increase and more people are priced out of the market.
Bottom line: The Fed has a tough job ahead, but the first signs of a slowing housing market have started to appear, and this is good news for the US economy. Perhaps the biggest risk is that the strong increase in mortgage rates could be too much for the housing market and the overall economy. For now, the nascent slowdown in the housing market seems to have not affected other sectors of the economy. If this continues to be the case the Fed may be able to engineer the many times elusive soft landing. Only time, and incoming data, will be able to tell.