Understanding the Impact of a New Administration on Interest Rates
Predicting the exact trajectory of interest rates over the next two to four years remains challenging, as even experts lack a crystal ball. However, many economists have shared insights on how the new administration's policies could influence these rates. To grasp these predictions, it's essential to understand the mechanics of interest rates and the factors that cause them to fluctuate.
Factors Influencing Interest Rates
1. Inflation Dynamics:
- Rising Inflation: When inflation increases, interest rates typically follow suit. Higher inflation erodes the purchasing power of money, prompting central banks to raise rates to cool down the economy.
- Falling Inflation: Conversely, decreasing inflation usually leads to lower interest rates as the central bank seeks to stimulate economic activity.
2. Federal Reserve Policies:
- The Federal Reserve (Fed) plays a crucial role in managing inflation and maintaining maximum employment through its control of the federal funds rate.
- For instance, from March 2022 to July 2023, the Fed raised the federal funds rate to between 5.25% and 5.5% to curb accelerating inflation, targeting a 2% inflation rate.
- Interestingly, in September 2024, despite core inflation figures of 2.7% (PCE) and 3.3% (CPI), the Fed lowered the federal funds rate to support maximum employment as unemployment edged above 4%.
New Administration's Economic Strategy
The new administration aims to boost job creation, productivity, and economic growth. A significant component of this strategy involves addressing the trade imbalance through tariffs:
- Tariffs on Imports: By imposing tariffs—a tax on imported goods and services—the administration seeks to increase domestic income and reduce the trade deficit. Currently, imports significantly exceed exports, contributing to national debt.
- Encouraging Domestic Production: The goal is to stimulate domestic manufacturing of taxed goods and services, stabilizing prices and reducing reliance on imports. However, this transition may take time, potentially leading to short-term inflationary pressures as prices of goods and services rise.
Implications for Interest Rates and Mortgage Rates
1. Interest Rates Stability:
- If the administration successfully manages to control inflation despite high-priced goods and tariffs, interest rates may remain relatively stable, hovering in the mid-6% to low/mid-7% range as many economists predict.
- However, if inflation rises due to increased prices from tariffs, the Federal Reserve may need to intervene by raising interest rates to maintain economic stability.
2. The 30-Year Fixed Mortgage Rate Conundrum:
- Unlike the federal funds rate, the 30-year fixed mortgage rate is influenced by the mortgage-backed securities (MBS) market. Investors' demand for these securities directly affects mortgage rates.
- In September 2024, Freddie Mac reported an average 30-year fixed rate of 6.09%. Despite the Fed lowering the federal funds rate to support employment, the 30-year fixed rate increased in subsequent months. This paradox occurs because lowering the federal funds rate can increase the money supply, fueling inflation and reducing the attractiveness of MBS, prompting investors to demand higher returns.
- The Fed does have tools to influence mortgage rates, such as purchasing MBS to increase demand and lower yields. However, these measures are complex and can only partially mitigate rising mortgage rates.
Balancing Act: Inflation vs. Employment
The Federal Reserve faces a delicate balancing act:
- Controlling Inflation: The primary tool is adjusting the federal funds rate to influence economic activity and inflation.
- Maximizing Employment: Lowering rates can stimulate job growth but may also lead to higher inflation if not managed carefully.
With the new administration's focus on economic growth and job creation, the Fed might prioritize keeping inflation in check to sustain long-term economic stability. If successful, interest rates may not fluctuate dramatically, and the current rates could persist longer than some expect.
Looking Ahead: What to Expect
For those in the market for a 30-year fixed mortgage, patience may be necessary for a long time. Given the current economic strategies and the Fed's dual mandate to manage inflation and employment, significant drops in mortgage rates might not occur as soon as you think. Unless an unexpected "black swan" event disrupts the economy and forces the Fed to take extraordinary measures, interest rates are likely to remain close to where they are today.
While no one can predict the future with certainty, understanding the interplay between government policies, Federal Reserve actions, and economic indicators provides valuable insights into the potential direction of interest rates. For now, the consensus suggests that interest rates may stay relatively high, and those considering long-term loans should prepare for this environment.