The Federal Reserve adopted a number of assertive, if not extraordinary, accommodative policies during and after the Great Recession to encourage investment and housing market activity. Among these policies was an effective zero-interest rate level for the federal funds rate, the short-term target rate. However, due to the severity of the recession, many economists argued that a zero-interest rate did not offer enough stimulus, particularly with respect to long-term interest rates that drive business and home purchase decisions.
The Fed also enacted the program of “qualitative easing,” by which it purchased U.S. Treasury bonds and mortgage-backed securities. These purchases raised bond prices, which in turn lowered long-term interest rates. However, quantitative easing significantly increased the Fed’s balance sheet. By 2014, the Fed held $4.5 trillion of such assets, including $1.75 trillion in mortgage-backed securities (MBS).
As U.S. labor conditions increasingly tighten, the Fed is moving from an accommodative policy stance to actions intended to normalize policy to combat rising prices. These include increasing the federal funds rate, as well a plan to reduce the Fed’s balance sheet closer to historic norms. I have argued from the supply side that home building itself can act as tool to fight inflation because more housing supply helps control increasing rent and housing prices.
The Fed recently detailed its “gradual and predictable” balance sheet strategy. It will decrease reinvestment of principal payments as defined by certain caps. For MBS, this monthly cap will start at $4 billion. The monthly cap will then increase in $4 billion steps over three-month intervals until rising to $20 billion. With these caps in place, the balance sheet will gradually decline likely beginning at the end of 2017. NAHB anticipates an incomplete reduction of the balance sheet over the next four to five years. While the Fed has noted that the federal funds rate is its preferred monetary policy tool, it also has indicated that it could restart quantitative easing if the economy falls into a recession.
What impact will these moves have on housing? Increases in the federal funds rate will place modest upward pressure on mortgage interest rates. Similarly, the reduction in the Fed’s balance sheet holdings of MBS will also increase mortgage rates. However, the NAHB Economics group estimates that this policy will increase rates by only about 10 to 15 basis points.
Overall, these policies, in tandem with a tightening labor market, will cause interest rates to increase over the next few years. NAHB is forecasting the 30-year fixed-rate mortgage to rise to almost 5% during 2019. While this would represent an increase over rates that prevailed in recent years, such levels will still be historically low. Increasing wages should help support housing demand during this necessary period of transition.
