The Federal Reserve Dilemma
Whether financing a television, a car, a home, we have been enjoying the fruits of historically low interest rates for several years. These low rates have significantly increased our purchasing power and affordability. That new car became exceptionally more attractive with a 2% interest rate than at 7%. Would you have bought the new home for the same price if the interest rate was 6% instead of 4.25%? Conversations about the economy’s health have become synonymous with interest rates. To raise, or not to raise, that is the question facing the Federal Reserve and a dilemma they are faced with at each meeting in recent months. With a strengthening economy, manageable unemployment, and increased confidence, determining the right time to pull back on the buyback program and start raising rates is a sensitive situation with many moving parts. We are in a fascinating stage of the economy and brilliant individuals are making reasonable arguments on both sides as to how to maximize our economic health and provide stability into the coming years. With so much conversation and debate on the topic of economic health, I thought it was timely to address the topic and discuss some of the arguments.
Leaving the Fed Funds Rate at .25% to continue stimulus to the economy is one methodology because that group thinks it is not strong enough independently and to raise the rate prematurely will create a stall to our fragile recovery. We are seeing continued global demand for US investments and bonds and though we are heading in the right direction, one can argue we are not at a state of balance. Unemployment has been declining, but at the same point many people are dropping out of the labor market and with so much turmoil in the global marketplace, taking a position of the status quo to maintain the current trajectory may be better than the unintended consequences of the unknown. When considering real estate values, the low rate has enabled many people to buy homes they could not otherwise afford because the affordability is dramatically higher.
The high affordability also helped sellers, especially those downsizing, because they benefited by higher sales prices; the high demand and affordability drove up the price with double digit growth over the past several years. Those higher profits have enlarged bank accounts or invested in this never-ending stock market rally. We had a perfect storm after the financial meltdown with low prices and interest rates, seeing historically high affordability. As prices have risen and interest rates have stayed relatively stable, we have seen a decline in affordability, albeit dramatically improved by the low cost of borrowing money. Keeping the Fed Fund Rate at this historically low percentage continues to stimulate the economy and increase wealth for many, but at what point are we also creating a false reality with unrealistic expectations being set?
If the Fed waits too long to raise the rate they may be caught in a situation of catch-up forcing them to make abrupt changes and dealing with the undesired effect of inflation. The other side of the coin is to make changes sooner than later because waiting too long will have a greater negative impact. The markets have rebounded, confidence is up and people are back to work. What is the Fed waiting on to start the process of ticking up rates? At each meeting the Fed is vague and ambiguous as to their timeline and that uncertainty causes fear in investors and forces people to sit back and wait.
With the current global landscape we are experiencing a great amount of foreign investing. The practically free cost of borrowing money has made it very attractive for many and we continue to hear that not much is changing in the short term period. With regards to real estate, increased interest rates and shrinking the bond buyback program may dramatically affect the growth of the market, especially in the short term, with affordability changing rather quickly and less government involvement in purchasing loans. However, it appears that the secondary market is back to loving real estate again and is buying up loans as fast as they are available. The higher interest rates would net a higher return to investors buying these securities. Part of the fear is stalling the real estate market with the increased cost of borrowing money. Real estate is one the closest watched indicators by the Fed because it affects so many people and is usually an indicator on the health of the economy. The question I continue to pose is whether the real estate market has enough demand to withstand an increasing interest rate environment. Unfortunately, I think that is a question that will only be answered once it is experienced.
Given both arguments, how does one make decisions on living, investing, or buying/selling their new home? Our current market is very different from previous markets, so it is important to think through a strategy unlike any other. Should you have aggressive investments or conservative? Keep a larger savings account or run it dry because the money keeps flowing? I think it is prudent to be somewhat cautious because of the uncertainty and risk of the alternative. If you are conservative and we continue to have a big run on the market, you’ll lose out on some big gains, but if you bet big and the market changes, the risk of loss could be much greater. If you are considering selling your home and making a life change, it can be very advantageous. Many neighborhood prices are at levels never experienced and you can reap the benefit of the low interest rate or cash buyer. If you are buying, let’s find you the right property, not just any property. One of the errors that people made during the last market cycle was settling on a property that did not fit their family needs and when the market changed they were stuck in a property that didn’t work. Let’s find you a home that fits your needs while taking advantage of the interest rate level. We can hypothesize about the future, but no economist, politician or investor truly knows how the pieces will fall as the market progresses. One of the most fascinating things in life is to experience how situations can vary based on individuals decisions, emotions and peer pressure. The market is dynamic, exciting, ever-changing, and we are living right in it. The Fed will continue their meetings and talk through the many variables and hopefully soon there will be clarity to their dilemma.