Question

(Related to the Chapter Opener on page 994) In its 2016 Annual Report, Toll Brothers noted, "If mortgage interest rates increase significantly ... our revenues, gross margins, and net income could be adversely affected." a. Why might an increase in mortgage interest rates reduce revenue and profit for Toll Brothers? b. During this period, was Fed policy attempting to reach a point on the short-run Phillips curve representing higher unemployment and lower inflation or a point representing higher inflation and lower unemployment? Briefly explain. c. What connection is there between Fed policy and Toll Brothers' concern about the effect of rising mortgage interest rates on its profit?

Short answer

An increase in mortgage rates might reduce the demand for homes, impacting Toll Brothers' revenue and profit. The Fed's policy during the period isn't specified, but they could have been trying to control either inflation or employment stability. If the Fed's policy led to higher interest rates, it would directly impact Toll Brothers' business by potentially decreasing the demand for homes.

Step-by-step solution

Identify the impact of mortgage interest rates on Revenue and Profit

If mortgage interest rates increase, it makes it more expensive for people to borrow money to buy homes. As a result, demand for buying homes might decrease, leading to a reduction in Toll Brothers' revenue. Since the cost of production and operation might remain the same or increase, with decreased revenue, the profit margin might also shrink.

Explore Fed's Policy

The Federal Reserve's policy during the period isn't explicitly mentioned in the exercise. However, if we assume the Fed was attempting to control inflation and retain employment stability, two scenarios are possible. If the Fed aimed for higher unemployment and lower inflation, they would likely raise interest rates to control inflation. If their target was higher inflation and lower unemployment, they would reduce interest rates to stimulate economic growth.

Establish the connection between Fed's policy and Toll Brothers' concern

The Federal Reserve can influence mortgage rates through its policy. If they raise interest rates to control inflation, mortgage rates might also increase. This is a concern for Toll Brothers because, as identified in step 1, increased costs of borrowing can reduce demand for homes, affecting their revenue and profit margin.

Key concepts

Mortgage Interest Rates

Mortgage interest rates are essentially the cost a borrower needs to pay for taking a loan to buy a house. These rates play a critical role in determining the affordability of homes for potential buyers. When mortgage rates are low, borrowing is cheaper, making it easier for more people to buy homes.
When these rates increase, the cost of monthly mortgage payments also rises, which might deter some potential buyers from entering the housing market.

• Higher mortgage rates increase the monthly cost for mortgage payments.
• Potential buyers may put off purchasing a home due to higher financial burdens.
• This leads to a decrease in demand for housing.

Understanding these dynamics allows companies like Toll Brothers to anticipate market trends and adjust their strategies accordingly. An increase in rates can lead to fewer home sales, which negatively impacts revenue and profit.

Federal Reserve

The Federal Reserve, often referred to as the Fed, is the central banking system of the United States. It plays a substantial role in managing the country's monetary policy, primarily by adjusting the federal funds rate. This rate is influential because it affects a wide range of interest rates, including mortgage rates.

• By raising the federal funds rate, the Fed can restrict economic activity to prevent inflation.
• Conversely, lowering the rate encourages borrowing and spending, stimulating economic growth.

The decisions made by the Federal Reserve can have widespread ripple effects on various economic sectors, including real estate, as changes in the federal funds rate typically lead to changes in mortgage interest rates. In times of high inflation, the Fed might increase rates, inadvertently affecting home affordability and companies like Toll Brothers.

Phillips Curve

The Phillips Curve illustrates an inverse relationship between the rate of unemployment and the rate of inflation within an economy. According to this concept, when unemployment is low, inflation tends to be high, and vice versa. The curve suggests a trade-off between inflation and unemployment in the short run.

• A position on the curve with lower unemployment typically associates with higher inflation rates.
• Conversely, a point with higher unemployment suggests lower inflation.

Fed policy usually attempts to find a balance on this curve by adjusting interest rates. During periods when the Fed desires to lower inflation, it may increase interest rates, which can lead to an increase in unemployment and a drop in inflation. These monetary policy decisions directly impact the housing market, including the dynamics Toll Brothers navigates.

Housing Market Impact

Any changes in mortgage interest rates, driven by Federal Reserve policies, can significantly impact the housing market. A hike in these rates generally results in a cooling effect on the housing market, as evidenced by reduced housing demand.

• Increased costs of borrowing dissuade potential buyers, decreasing demand.
• Fewer home sales can reduce home prices, affecting builders and real estate companies.

For companies like Toll Brothers, which specialize in home construction, the implications are clear: higher mortgage interest rates might lead to decreased sales volumes, lower revenues, and diminished profit margins. Thus, understanding the interconnectedness of Fed policies and housing demands is crucial for stakeholders making strategic business decisions.