How price rises will affect your mortgage, pension, and more

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n response to skyrocketing inflation, the Federal Reserve is expected to begin hiking up interest rates. This will have tremendous ripple effects throughout the entire economy — from investment decisions being considered in corporate boardrooms, to the weekly shopping list you compile at your kitchen table.
What changes can you expect to see in your daily life? How will these changes affect your purchasing decisions, from groceries and gasoline to a new house? How can you make the best choices, and how can you hedge against inflation?
We assembled a panel of three expert economists who are veteran observers of the Federal Reserve and the various stock market indexes. They give their views on household spending, borrowing, and investing.

Members of the panel:
John Cochrane, economist and senior fellow at the Hoover Institution
Aris Protopapadakis, emeritus professor of finance and economics at the University of Southern California Business School
Jay Ritter, Joseph B. Cordell Eminent Scholar in the department of finance at the University of Florida

Why did the Fed increase rates? And how will the higher rates affect daily life, from grocery bills to loans?

Bottom line — increased rates are a tool to curb spending, to encourage people to save rather than consume, and thus get inflation under control.
The bad news —you will pay more for certain types of mortgages and new loans.
The good news — it should bring down your grocery prices.

In the experts’ words:
Protopapadakis: “Increasing rates is essentially the only tool the Fed has to combat inflation. The idea is that the higher interest rates slow down economic activity, primarily on the real investment side — corporate and real estate — and therefore slow down inflation. If the Fed overdoes it, which is easy to do, then we could have a recession.
“So loan rates will go up, longer term bond yields will rise, stock prices will fall some, and your bank will pay a little more interest. And within a couple of quarters — maybe sooner in this case — inflation will slow down. It doesn’t mean prices will fall, though undoubtedly some will, it just means that on average they will rise more slowly. There will be fewer job openings, and some people may lose their jobs.”
Cochrane: “The basic idea is that making borrowing more expensive will cause people to buy less stuff, putting less upward pressure on prices. People will also have more of an incentive to save rather than spend money.”
Ritter: “With inflation at 7 percent and short-term interest rates near zero, the ‘real’ interest rate is negative. People have little incentive to save as a result, and spend more, pushing prices up further. To keep rates low, the Fed would have to rapidly expand the money supply, resulting in more inflation. In Turkey, the government’s attempt to keep interest rates low has set off an inflationary spiral, with an inflation rate of over 30 percent per year. The US Federal Reserve is allowing interest rates to rise in order to avoid the type of inflationary spiral that Turkey is currently suffering from.”

How will rising interest rates affect homeowners and other borrowers?

The bad news: Mortgage rates will rise, which will obviously hurt borrowers.
The good news: It will happen gradually, and even after the expected four rate hikes by the end of 2022, mortgage rates will remain historically low.

Hear it from the experts:
Ritter: “We have seen a drop in real interest rates during the last 40 years, both in the US and worldwide. The drop in interest rates has pushed up asset prices. But in areas where land is cheap, the main determinant of house prices is construction costs. It is only where land is scarce that we have seen big increases in housing prices.
“The higher housing prices go, the bigger the chance that they might fall. When interest rates increase, this might become a problem. There is also the issue of affordability. As prices increase, the size of the down payment, normally 20 percent or more, increases. A larger down payment means that young people have to wait longer to afford a purchase.”
Protopapadakis: “Borrowing will be more expensive, so the real estate market will slow down, but it is very unlikely we’ll see falling housing prices. Just remember that at least traditionally, the Fed raises its interest rate (called the Fed funds rate) by 0.25 percent at a time. We are not talking about very big changes here. Four raises this year would amount to 1 percent.”
Cochrane: “If you are planning to buy a house, get your mortgage yesterday, refinance floating to fixed (still a good deal in my view), and sell your stocks yesterday! As interest rates rise, mortgage rates will rise. Homeowners who plan to stay in their houses a while shouldn’t worry too much. And if house prices go down, the house you want to buy goes down as much as the one you want to sell. If you want to downsize and live off the proceeds, you’re in a tougher position. Houses are terrible investments. Treat them like cars or TVs, durable goods — not like stocks.”

Why do you think a house is a terrible investment?

Cochrane: “A house is a thing, which is nice to live in. A stock is a share of a company, which produces something and makes profits. Some houses go up, but over the long run, houses have had a much worse return than companies or other productive assets. They also are much less liquid, and have a lot of idiosyncratic risk — will this city or neighborhood rise or fall?”

Why are we seeing Wall Street tumbling for the past four weeks?

The bad news: The stock market might continue to show weakness, specifically when it comes to growth and tech stocks, and more specifically, those that skyrocketed in 2021 without showing profits and are now falling back to earth.
The good news: If you are invested in the stock market for the long run, and your portfolio is diversified, it shouldn’t matter to you. It will take time, but the markets will rise again.

Hear it from the experts:
Cochrane: “While one can never know for sure what sparks the collective wisdom of the market, it looks pretty clear that the market is going down as people see higher interest rates coming out of the Fed.
“Higher interest rates make bonds more attractive, so people try to sell stocks and buy bonds, sending down stock prices. But prices decline until the returns are higher, as high as bonds are, so this is not terrible news for long-term investors. If you’re not a long-term investor, you shouldn’t be buying a lot of stocks anyway.”

Some stocks have fallen 50 to 80 percent in the past six months, and are actually oversold. How come we still barely see any dip-buying (that is, people buying the lower-priced stocks)?

Cochrane: “Well, some of those were ‘overbought’ to begin with. Really, was GameStop ever going to conquer the universe? And don’t forget, for every buyer, there is a seller. Other stocks, like growth and tech stocks, have a long way to go before they earn any money. They are more sensitive to higher interest rates.”
Protopapadakis: “I have often said that the stock market is the drama queen of the financial markets. When the markets decided that the Fed was serious about raising rates and was not just stopping bond-buying, I think they panicked a little. The other factor is what might happen in Ukraine and how that would affect the European economy. A more distant worry is China — does it do another lockdown and slow its economy down.”
Ritter: “Although the stock market has dropped from its historic highs, the stocks that have dropped the most have generally been growth stocks. These are the same stocks that had the biggest run-ups in the last few years, companies such as Tesla and Peloton, and also lesser-known stocks such as Paycom, a software company.
“Many of these stocks had seen their stock price increase faster than earnings (if they had earnings), resulting in very high price-earnings ratios. Many value stocks, such as Colgate Palmolive and General Mills, had not seen big increases, and have not seen big falls. So in one sense, we are seeing a reversion toward the mean.”

Why are rising interest rates driving people away from the market? What is considered a safe haven for capital in times of inflation?

The bottom line: Short-term investors might consider buying Treasury Inflation-Protected Securities (TIPS), but long-term investors will still get a better return in the stock market.

Take a deep dive with the experts:
Ritter: “Probably the best safe haven for protection against inflation is TIPS, for which the price automatically increases when inflation is high. Last year, they outperformed almost all other bonds because inflation was higher than had been expected.”
Protopapadakis: “The Fed controls the shortest of the short-term interest rates. However, the expectations of further future increases in the rate will be reflected in the much longer-term rates, and that affects corporate decisions, corporate investments, and of course the real estate market.
“When interest rates rise, future profits are discounted more heavily, and thus share prices fall. However, historically, the stock market has done well with rising interest rates, probably because the rates rise in the context of an economy that is growing quickly, as it is now.
“For long-term inflation — and I mean long — stocks and real estate. Right now, the ‘safest’ investment would be government-indexed bonds, which have a slightly negative real rate of return, but that return would be unaffected by inflation.”

(Originally featured in Mishpacha, Issue 897)