Remember how everyone thought interest rates would be slashed this year? Buckle up, because the Federal Reserve just switched gears, and now the mantra is “higher for longer.” Let's unpack what this means for your wallet, your home, and the overall economy.
Buckle Up: Higher Interest Rates for Longer Than Expected
Why the Sudden Shift?
As of May 2024, the inflation rate in the United States was 3.4% for the 12 months ending in April. This is higher than the long-term average of 3.28%. The main contributors to inflation are currently shelter, motor vehicle insurance, and energy.
Despite these high inflation numbers, just six months ago, the Federal Reserve thought they were about to achieve a soft landing for the economy.
However, inflation continues to soar, surpassing every prediction. Consumers are spending more than anticipated, the job market stays tight, and even higher interest rates haven't significantly impacted real estate.
Fed to Hold Rates High: Inflation Target Pushed to 2025
What Exactly is “Higher for Longer” Interest Rates?
The Federal Reserve is trying to cool down the economy by raising the federal funds rate. This is the interest rate that banks charge each other to borrow reserves overnight.
By making it more expensive for banks to borrow money, the Fed discourages them from lending freely. This, in turn, makes it more expensive for businesses and consumers to borrow money as well. Higher borrowing costs lead to slower spending and investment, which can help to bring inflation under control.
The Fed's goal is to achieve a soft landing, where the economy slows down gradually without tipping into a recession. However, there's a delicate balancing act here. If the Fed raises rates too aggressively, it could trigger a recession. But if they raise rates too slowly, inflation could spiral out of control.
The “higher for longer” approach reflects the Fed's commitment to keeping interest rates elevated for a sustained period. This is a departure from their previous strategy of raising rates and then cutting them back down again after a while. The Fed is now signaling that they are willing to keep rates high until they are confident that inflation is under control.
When Will Mortgage Rates Drop?
The bigger question might be: will they fall at all? With inflation double the Federal Reserve's target, there's a chance rates could climb even higher. As of June 06, 2024, the interest rate on a 30-year fixed-rate mortgage is 6.99%, and the rate for a 15-year fixed-rate mortgage is 6.29%. These rates are unchanged from the previous week.
The Fed doesn't directly control mortgage rates, but they do influence them through the federal funds rate. This is the rate banks charge each other for overnight loans. In simpler terms, it's the interest rate banks earn on their cash reserves.
Here's the catch: mortgage rates aren't “set” by any one entity. They're generally based on the 10-year Treasury yield. This yield has been rising, and as a result, mortgage rates have followed suit.
Don't expect a significant drop in rates anytime soon. A reset will likely only occur when consumer spending slows down, possibly due to a recession or economic correction. Until then, brace yourself for steady or even higher rates.
How Will This Affect Real Estate?
Before COVID, a significant rise in interest rates would have sent housing prices plummeting. We're seeing a different story this time around, at least for now. Strong wage growth and low unemployment are keeping prices flat or even increasing – the opposite of what we might expect in a typical economic slowdown. However, this is likely a temporary reprieve.
Higher interest rates make it more expensive to buy a home. This reduces demand, which should eventually lead to lower prices. Additionally, as rates rise, some homeowners who bought with low-interest mortgages in recent years may find themselves underwater on their mortgages (owing more than their home is worth) if home prices fall.
This could lead to a wave of foreclosures, which would put downward pressure on prices even further. It's important to remember that the housing market is local. Some areas may be more susceptible to price declines than others.
For example, areas with a high concentration of expensive homes or a large number of second-home buyers could see steeper price drops. Conversely, areas with a strong job market and a limited supply of housing may be more resilient.
Commercial Real Estate: A Different Story
The party's already over for many commercial properties, especially offices. Higher interest rates, coupled with high vacancy rates and lower rents, are spelling trouble for many landlords.
Delinquency rates on commercial mortgage-backed securities (CMBS) have been rising steadily, with office properties being hit the hardest. This trend is likely to accelerate as higher interest rates continue to squeeze the market.
Beyond the immediate challenges, there's a question of what the future holds for office space in general. The pandemic ushered in a significant shift to remote work, and many companies are rethinking their office space needs. This could lead to a long-term decline in demand for office buildings, putting further downward pressure on prices.
Are We Headed for a Recession?
Just half a year ago, a soft landing seemed almost guaranteed. However, consumer sentiment is dropping despite positive economic news. This could be a red flag for what's to come.
Higher interest rates significantly increase the chances of financial issues cropping up across various sectors. The big question: which domino will tip first? Will it be commercial real estate, banks, the stock market, overextended businesses or consumers, or something entirely unforeseen?
As rates remain high, the risk of these problems snowballing into a full-blown recession grows. This is especially concerning considering the market is currently predicting the opposite – a soft landing.
The Bottom Line
“Higher for longer” isn't good news for the economy or real estate. It's like slowly peeling off a bandage instead of ripping it off quickly. The longer rates stay high, the greater the chance of a recession as economic risks multiply.
Commercial real estate, particularly office space, is a leading concern. But as rates stay elevated, other sectors like multifamily housing, which are highly sensitive to interest rates, could also get dragged into the downward spiral.
Residential real estate is holding up surprisingly well for now. This complicates things further because rising home prices are actually fueling inflation. For inflation to cool down and for higher rates to eventually lead to lower borrowing costs, housing prices and rents would need to fall substantially – a scenario the market isn't currently pricing in.
The Federal Reserve's strategy of higher interest rates might backfire. While they aim to control inflation and achieve a soft landing, they could inadvertently lock in inflationary pressures and push the economy towards a recession. The true impact of this shift will likely only become evident later this year or even in 2025. There's a balancing act of raising rates enough to curb inflation without choking off economic growth altogether.
What You Can Do to Prepare
With economic uncertainty looming, it's wise to take proactive steps to safeguard your financial well-being. Here are some tips:
- Review your budget and spending habits. Identify areas where you can cut back and free up some cash. This will give you a buffer if your income decreases or expenses rise.
- Build up your emergency savings. Aim to have enough money saved to cover at least 3-6 months of living expenses. This will help you weather any financial storms that come your way.
- Minimize debt. Pay down existing debt as aggressively as possible. The less debt you have, the less vulnerable you'll be to rising interest rates.
- Diversify your investments. Don't put all your eggs in one basket. Invest in a variety of assets, such as stocks, bonds, and real estate (if you have a long-term investment horizon). This will help to mitigate risk.
- Stay informed. Keep an eye on economic news and trends. This will help you make informed decisions about your finances.
Remember, this too shall pass
Economic cycles are inevitable. There will be periods of boom and bust. The key is to be prepared for both. By taking steps to shore up your finances now, you can weather the storm and come out stronger on the other side.
For homeowners: If you're concerned about rising interest rates impacting your mortgage payments, consider talking to your lender about refinancing your loan if you qualify for a better rate. You may also want to consider a fixed-rate mortgage if you're currently on an adjustable-rate mortgage (ARM) to lock in a stable interest rate.
For renters: If you're concerned about rising rents, consider negotiating a longer-term lease with your landlord to lock in a stable rent price. You may also want to shop around for more affordable rental options.
For investors: Be prepared for potential volatility in the stock market. Consider investing in defensive stocks that tend to hold their value better during economic downturns. You may also want to increase your allocation to bonds, which can provide some stability to your portfolio.
By following these tips, you can take control of your finances and navigate the economic uncertainty ahead with more confidence.
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