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The Fed tackles inflation: Three possible scenarios for mortgage rates

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As mortgage rates surge and everyone awaits the Federal Reserve’s next move, market watchers are fixated on the dramatic rise in consumer prices. Inflation, and the Fed’s response to it, will drive mortgage rates in the coming year.

“Inflation, inflation, inflation,” says Greg McBride, Bankrate’s chief financial analyst. “That’s really the hub on the wheel.”

Inflation jumped to 7.9 percent in February — and that was before the Biden administration’s sanctions on Russia pushed energy prices higher. With consumer prices surging, the Fed is all but certain to raise rates seven times this year, says Diana Furchtgott-Roth, an adjunct professor of economics at George Washington University and former chief economist at the U.S. Department of Labor.

“The economy doesn’t like inflation,” Furchtgott-Roth says. “We have to get inflation out of the economy.”

The new reality of rising prices is roiling mortgage rates. In January 2021, the average rate on a 30-year mortgage fell to an all-time low of 2.93 percent, according to Bankrate’s weekly national survey of lenders. As of last week, that number had climbed to 4.59 percent — and many housing economists say 5 percent rates loom on the horizon.

How the Fed’s moves might affect mortgage rates

Furchtgott-Roth says the Fed has little choice but to move aggressively to contain inflation. In other words, a sharp rise in rates is coming.

“We have never got inflation out of the economy by having a federal funds rate that’s lower than the inflation rate,” Furchtgott-Roth says. “We’ve only got inflation out of the economy by having a federal funds rate that’s higher than the inflation rate.”

While the Fed plays a powerful role in managing the economy, the data it considers is often contradictory, and the central bank’s tools aren’t especially precise. Therefore, it’s unclear how the Fed’s policies will play out.

McBride envisions three possible outcomes:

  • Scenario 1: Inflation stays stubbornly high, forcing the Fed to raise interest rates repeatedly. In this scenario, mortgage rates will keep climbing.
  • Scenario 2: The consumer price index responds to the Fed’s initial rounds of rate hikes, inflation tempers and mortgage rates hit a plateau, then pull back a bit.
  • Scenario 3: The Fed raises rates repeatedly to curb inflation, and the economy falls into recession. If this script plays out, mortgage rates would beat a quick retreat.

The most likely outcome for 2022, McBride says, is Scenario 1. The Fed fights persistent price increases, and mortgage rates rise.

It’s also plausible that Scenario 3 will play out in 2023 — the economy goes into contraction phase and mortgage rates fall.

Why mortgage rates are spiking

The forces driving mortgage rates are complex, but four factors are playing a major role right now:

1. Inflation is running hot

To stave off a pandemic-induced collapse, the Fed in 2020 slashed rates to zero, and the federal government pumped trillions of dollars of stimulus into the economy. Those efforts worked — perhaps a little too well. “There is such a thing as too much of a good thing,” Furchtgott-Roth says. Now, inflation is rampant. The consumer price index jumped 7.9 percent in February, the swiftest annual pace since the bad old days of the early 1980s, according to the Labor Department. That’s forcing the Fed’s hand.

2. The labor market has rebounded

The pandemic sent the U.S. economy into a deep recession, and unemployment soared. That brief crash is now in the rearview mirror. Employers added a robust 678,000 jobs in February, the. Labor Department reports, and the unemployment rate fell to just 3.8 percent, a level that fits any definition of full employment.

3. The Fed is poised to act aggressively

The central bank raised rates in mid-March, and the Fed has signaled that multiple hikes are coming. Chairman Jerome Powell and company could boost rates as many as seven times this year. The Fed also is slowing the pace of its purchases of mortgage-backed securities, a move that creates upward pressure on rates. The Fed doesn’t set mortgage rates, but it creates the overall tone.

4. The 10-year Treasury yield has risen sharply

This figure is closely tied to 30-year mortgage rates, and the 10-year yield has topped 2.3 percent in recent days. Yields on federal debt reflect the overall economy. When the economy crashed in 2020, 10-year rates plunged below 1 percent. Now, they’re back.

Next steps for borrowers

Here are some tips for dealing with the new climate of rising interest rates:

  • Shop around for a mortgage. Savvy shopping can help you find a better-than-average rate. The refinance boom has ended, leaving lenders eager for your business. “Conducting an online search can save thousands of dollars by finding lenders offering a lower rate and more competitive fees,” McBride says.
  • Avoid ARMs. “Don’t fall into the trap of using an adjustable-rate mortgage as a crutch of affordability,” McBride says. “There is little in the way of up-front savings, an average of just one-half percentage point for the first five years, but the risk of higher rates in future years looms large. New adjustable mortgage products are structured to change every six months rather than every 12 months, which had previously been the norm.”
  • Keep a cash-out mortgage in mind. While mortgage refinancing is on the wane, it can still make sense in some cases. Home prices have soared, and mortgage rates remain low enough that tapping home equity is the best way to finance home improvements.
Written by
Jeff Ostrowski
Senior mortgage reporter
Jeff Ostrowski covers mortgages and the housing market. Before joining Bankrate in 2020, he wrote about real estate and the economy for the Palm Beach Post and the South Florida Business Journal.
Edited by
Mortgage editor