The United States economy has been rocked in 2022 and mid 2023 by the highest inflation in over 40 years. This intense bout of rising prices is sending shockwaves across the financial landscape, perhaps most visibly in its twin strikes on mortgage rates and consumer spending. With further inflation volatility anticipated, the housing market and household budgets remain squarely in the crosshairs.
Mortgage Rates Spiral Upward as Inflation Soars
Inflation’s sharp rise this year directly catalyzed a dramatic liftoff in mortgage rates. Behind this close link is the Federal Reserve, which has been aggressively raising interest rates to cool demand and restrain runaway inflation.
In October 2021, the average 30-year fixed mortgage rate still stood at an ultra-low 3.09%, according to Freddie Mac. But as inflation surged, the Fed has taken its benchmark rate from near zero to a target range of 3.75-4%, with more hikes to come. This swift monetary tightening has funneled through to mortgage pricing.
Come October 2022, the average 30-year fixed rate had more than doubled to 6.92% – its highest level since 2002 but as anticipated in October 2023 the average 30-year fixed rate is close to 8% . This ascent reflects the tight relationship between mortgage rates, Fed policy, and inflation. So long as inflation remains high, additional rate hikes are likely forthcoming from the Fed. And as goes the Fed, so too will mortgage rates.
“Mortgage rates have a direct relationship with inflation and the actions of the Federal Reserve to curb rising prices,” said Mark Zandi, chief economist at Moody’s Analytics. “With inflation still running hot, we can expect mortgage rates to continue trending upwards through 2023 and 2024.”
How much farther rates increase hinges on where inflation heads next. But some projections are already sounding alarms. The Mortgage Bankers Association warned that if inflation holds above 3% in 2024, average 30-year fixed mortgage rates could eclipse 9% by 2026. This would further undermine home affordability.
Housing Market Buckles as Rates Deter Buyers
On the front lines, these rapidly rising mortgage rates are taking a heavy toll on the housing sector. Higher financing costs have dealt a material setback to home affordability, pricing many buyers out of the market.
Existing home sales have borne the brunt of this downturn. As mortgage rates began surging in early 2023, sales of previously owned homes started a months-long decline. In September 2022, they hit a nearly 10-year low according to National Association of Realtors data. Home prices are also now retreating, with the median existing home price down 8% since June 2022.
“The new normal for mortgage rates is well above 6%,” said Lawrence Yun, chief economist for the National Association of Realtors. “This means home shoppers will face significantly higher monthly payments and steeper qualifying hurdles.”
Sharply reduced homebuilder sentiment confirms that builders are also feeling the chill of higher mortgage rates. Single-family housing starts are down more than 10% year-to-date.
As inflation boils and mortgage rates rise in response, this affordability squeeze looks poised to further dampen the once blistering housing sector, at least until pricing pressures ease substantially.
Consumers Strained by Inflation Onslaught
American consumers are likewise facing heightened financial strain from the inflation outbreak. Prices have soared across daily essentials from groceries, restaurant meals and gasoline to rent, clothing, medical care and utilities. This is severely stretching household budgets, requiring difficult trade-offs especially for lower-income families.
Grocery costs have become a notable pain point. Food prices leapt 13% year-over-year in September 2022, the largest annual increase since 1979. From dairy and meat to fruits, vegetables, and pantry staples, grocery bills are ballooning for US consumers.
Energy costs are also scaling multi-year highs, further squeezing consumers. Nationally, gasoline remains expensive at $3.80 per gallon as of October. Winter heating bills are likewise forecast to climb as much as 28% for natural gas and 14% for electricity.
“Consumers built up excess savings during the pandemic, which helped sustain spending despite inflation,” said Diane Swonk, chief economist at KPMG. “As pandemic savings deplete and household budgets tighten further, we can expect a more significant decline in discretionary spending.”
Early Signs of Shifting Consumer Behaviors
Facing these elevated costs for non-discretionary household basics, consumers have had fewer leftover funds for discretionary purchases. Many are opting for lower-cost grocery items and fast food in lieu of restaurants. Tips at eateries are down. Consumers are also capping travel plans and trimming back spending on experiences.
Rising reliance on credit cards points to some financial strain as well. Aggregate credit card balances jumped by over $100 billion during the first half of 2022 – the largest 6-month increase in over 20 years. This implies consumers are borrowing more to help offset inflation’s bite.
Meanwhile, major card issuers like Visa and Mastercard reported third quarter sales slowed significantly from 2021’s stimulus-fueled levels. This marks an abrupt cooldown in discretionary spending compared to last year’s blistering growth pace.
“We have seen down-trading in discretionary categories, reduction in travel and lower fuel consumption – all pointing to a squeezed consumer,” Visa CFO Vasant Prabhu told analysts in October 2022.
Still, some tailwinds persist. Consumers have accumulated a large stock of savings and pent-up demand after two years of constrained spending. The still-hot labor market is also helping cushion the inflation blow somewhat for now.
Nevertheless, consumers remain wary as long as inflation stays so painfully elevated. Any substantial rise in unemployment would likely spur much more significant pullbacks on discretionary retail spending.
Path Forward for Mortgages and Consumers Tied to Inflation’s Next Moves
Inflation appears to have passed its peak, but remains extremely high by historical standards. Whether mortgage rates and consumers find steadier footing in the coming year hinges critically on inflation continuing to moderate back towards the Fed’s 2% target.
Most economists expect another 75 basis point Fed rate hike in November, followed by a 50-75 basis point increase in December. Markets anticipate rates peaking around 5% in early 2023, unless inflation accelerates again.
More dovish projections see rates falling below 5% later next year if price pressures keep cooling. This path would ease the upward march in mortgage rates and support stronger consumer demand.
But the outlook faces risks from an energy supply crisis this winter or foreign downturns slowing US exports. Worsening inflation could harden Fed policy, while excessive tightening might unduly hamper growth.
The course ahead remains highly uncertain, with risks tilting to the downside. The upcoming midterm elections could stoke additional market volatility depending on the outcome. Meanwhile, the Fed faces a delicate balancing act trying to rein in inflation without excessively hampering growth.
The central bank has clearly signaled that restoring price stability remains its top priority, even if means risking recession. To thread this needle, the Fed must skillfully calibrate the pace of future rate hikes based on incoming data.
While no one can predict how smoothly this process will unfold, the base case is that persistent rate increases will help gradually tame inflation over the next 12-18 months. In this scenario, inflation cools to around the Fed’s 2% target by end 2023 or early 2024 without completely crushing economic growth.
If achieved, this “soft landing” would pave the way for both mortgage rates and consumer demand to stabilize and recover. The extreme pandemic-era swings in housing and consumption should moderate over time. Despite current strains, the underlying resilience of US households and housing markets remains intact.
Therefore, while the near-term outlook is clouded by inflation uncertainties, the most likely path beyond the next year or so seems one of steady rebuilding. Once unmoored inflation is reined in, mortgage rates and consumer spending power can hope to find firmer footing again.
For now, volatility and uncertainty prevail. But there is light beyond the inflation tunnel. With deft Fed steering, the pillars of housing and consumption could reemerge from the turbulence – perhaps strongly so – by 2024.