Higher Interest Rates Are Increasing the Wealth Gap, New Fed Working Paper Argues

When it comes to building generational wealth in America, mortgage rates are one of the most important factors to consider. Low mortgage rates can help you save money on your home loan and make it easier to afford a home, while high mortgage rates can make it more difficult to purchase a property.

The Federal Reserve's recent increases in benchmark interest rates may be exacerbating wealth inequality rather than reducing it, according to a new working paper from the central bank. That's down to the knock-on effect on mortgage rates, which have soared to multi-decade highs in recent months.

In contrast to the belief that lower interest rates tend to benefit the rich more than the poor, Federal Reserve Board Economist Daniel Ringo argues that lower interest rates can help low- and moderate-income families purchase homes and begin to accumulate wealth. This is achieved by pushing up the value of financial assets, such as bonds and stocks.

According to Ringo, monetary policy not only affects the value of assets, but also who is able to purchase those assets. While low-wealth households may not experience an immediate appreciation of financial assets when the stance of monetary policy is expansionary, that stance can allow them to get their foot in the door of homeownership.

The forced-savings nature of amortizing mortgage payments and house price appreciation can be a powerful wealth building tool for families over the decades. However, tighter policy appears to prevent many lower-income families from buying homes.

The paper uses mortgage application data to find that a tightening of monetary policy which increases mortgage rates by 1 percentage point reduces the share of home purchase loans going to low- and moderate-income borrowers by 2.1 percentage points (or 7.5%) in the weeks following the announcement. First-time home buyers are even more affected, with a 1 percentage-point tightening causing a 4 percentage-point fall in the share of loans going to low- and moderate-income households.

According to Ringo, being denied or discouraged from taking out a home purchase loan can have serious consequences for households that don't already own their home. Monetary policy is a key factor in determining who becomes a home owner, and how income-segregated home ownership becomes.

Ringo's work focuses on the immediate reactions of would-be home owners to changes in mortgage rates, but he also finds that benchmark rate hikes can have a longer-lasting effect on purchasing behavior.

According to one researcher, lower-income home buyers are less likely to purchase a home in the year following a contractionary monetary policy shock. This longer-term effect is less precise to estimate than shorter-term effects.

According to Ringo, the effects of a rate shock on home buyer composition don't seem to fade away over time as quickly as one might expect. House prices usually respond to such shocks and borrowers adjust by finding homes that fit their new budget, but these adjustments apparently happen slowly. This finding suggests that a one-time monetary policy decision can have a significant impact on the income composition of the stock of home owners by altering the composition of the inflow for an extended period of time.

Ringo's estimates suggest that a 1 percentage point increase in mortgage rates would stop about 260,000 low- and moderate-income households from buying a home in the subsequent year. This is based on the 1.5 million home-purchase loans made to low- and moderate-income borrowers in 2021 - the year before the Fed kicked off its most recent rate hiking cycle.

It's no surprise that benchmark rate hikes reduce demand for buying houses. Monetary policy works by tightening or loosening financial conditions, including the cost of credit. Meanwhile, the Fed has explicitly stated a desire to cool the labor market in its attempt to cool inflation. And job losses also reduce people's ability to buy houses.

The paper highlights a tension with the Fed's ambitions to promote a more inclusive economy, as well as a perhaps under-appreciated aspect of its monetary policy decisions.

According to Ringo, the literature has largely focused on how monetary policy affects wealth inequality through asset prices, without considering how it may also affect people's access to key asset classes. This paper shows that equality of access to assets is an important factor in determining wealth inequality.

The effects of homeownership on wealth accumulation take time to show up, so any influence of this access channel on wealth inequality would only be seen after a significant period of time. Estimates of the effect of monetary policy on wealth levels in the short term would therefore miss this effect.

There is a new Federal Reserve paper that has found that surging home prices are being driven by demand, not supply. This is an interesting development, and it will be interesting to see how it affects the economy going forward.