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March 2022
The Federal Reserve has changed its policy stance considerably in the last few months in reaction to elevated inflation and strong recovery in the labor market. Financial markets now point to about five 25 basis point interest rate hikes in 2022, in contrast with less than one predicted as recently as September 2021. This is on top of an accelerated end to its purchasing of Treasuries and mortgage-backed securities announced late last year.
Underlying the adjustment in Fed policy is a stark shift in the evolution of the two primary mandates of the Fed: maintaining stable prices and achieving full employment. The inflation rate on personal consumption expenditures rose by over five percent year-over-year in December, far outstripping the Fed’s two percent average price objective. This represents the strongest pace of inflation since the early 1980s. Meanwhile, the unemployment rate as of the end of last year had fallen to approximately 4 percent, signaling a much quicker improvement in the labor market than forecasted by Fed policymakers (see Table). The rise in inflation could carry disparate consequences across income groups. This poses challenging tradeoffs for the Federal Open Market Committee (FOMC)’s revised strategic framework, which has emphasized the redistributive benefits of a tight labor market.
| Forecasts of Inflation and Unemployment Rate for Year-End 2021 | |||
| FOMC Central Tendency (December 2020 Prediction) |
FOMC Central Tendency (June 2021 Prediction) |
Actual | |
| Inflation (PCE) (%) | 1.7 - 1.9 | 3.1 - 3.5 | 5.8 (4.9 Core) |
|---|---|---|---|
| Unemployment rate (%) | 4.7 - 5.4 | 4.4 - 4.8 | 3.9 |
*Source: FOMC Summary of Economic Projections (December 2020 and June 2021), FRED
Economic Data (FRED), and the Bureau of Economic Analysis (BEA) as of February 25, 2022.
Given the stark changes in the economic outlook and monetary policy, we highlight lessons from prior JPMC Institute research that shed light on the potential effects of Fed rate hikes on household financial health. We set these lessons in the context of substantial shifts in household balance sheets since the onset of the pandemic.
Savings stockpiles and retail stock market investment
- Disposable income and the personal savings rate has been high for most of the past two years, contributing to increases in liquid balances across the income distribution. By themselves, these trends suggest that, on average, households are well-positioned to weather tighter financial conditions resulting from Fed rate hikes.
- Consumers have increasingly channeled savings into stock market investments, which inherently carry risk. In research published last year, we documented strong growth in transfers to retail brokerage accounts around the onset of the pandemic, with the lowest income quartile experiencing the largest percentage rise. We also observed a strong tendency for such transfers to track short-term trends in the stock market, a pattern which can lead to losses in the event of a market pullback.
- With higher household balances on both extremes of the risk spectrum (from lower-risk checking account balances to higher-risk stock market investments), the trajectory of spending alongside rate hikes may be more differentiated than usual. Those with higher liquidity may offer a tailwind supporting demand this year, but households that recently increased their stock market investments (including first-time investors) could experience spending cutbacks in the event of a significant tightening in financial conditions. Given this potential heterogeneity, financial market wealth effects may be more difficult to gauge in the current environment yet remain an important part of monetary policy transmission to the economy.
Higher mortgage rates and elevated housing prices
- After experiencing price increases averaging about 20 percent since 2019, affordability is a core issue in the housing market. In the absence of a decline in home prices—unlikely given severely restricted housing supply coupled with increased demand—higher mortgage rates mean that homeownership may be even less attainable for many households, which would disproportionately affect households of color.
- Conversely, as holders of an asset that has appreciated rapidly, homeowners are sitting on record levels of housing wealth.1 Cash-out refinancing activity has increased steadily through 2020 and 2021, converting home equity into current consumption. JPMC Institute research has estimated that homeowners spend 33 percent of what they take out via cash-out refinances within one year. Less refinancing due to higher mortgage rates implies reduced consumer demand from that channel. This includes both cash-out and rate and term refinances.
- The majority of homeowners who have fixed rate mortgages will likely come out ahead with rising inflation and rates. However, for the relatively small subset of homeowners with adjustable rate mortgages (ARMs), a rising rate environment may cut into their consumption as their mortgage payments adjust upwards. JPMC Institute research has estimated that homeowners increase their spending by nine percent in anticipation of lower monthly payments when their ARMs reset downwards and 15 percent after the reset. If a similar pattern holds for ARMs resetting higher, homeowners with ARMs will be facing reduced spending power.
The Fed has to balance risks to consumers’ financial health resulting from tighter policy now against a potential deepening of financial vulnerabilities—including feeding speculative behavior in the stock and housing markets—that could result from a weak response to high inflation. Rate hikes tend to affect the population in a variety of ways that are difficult to gauge with precision. The recent sharp changes in household balance sheets and asset prices make it even more challenging to predict the effects of tighter policy. We believe continued advances in understanding household heterogeneity, supported by careful analysis of granular data, are an essential part of policymakers’ toolkits as we approach the impending rate hike cycle.
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