In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain how the Federal Reserve and tighter monetary policy may impact the housing market in 2022.
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“Mortgage rates typically follow the same path as long-term bond yields, which are expected to increase due to higher inflation expectations and an improving economy. And, as we focused on in this episode, Fed tightening, specifically when the Fed embarks on quantitative uneasing, is more likely to result in higher mortgage rates.” – Odeta Kushi, deputy chief economist at First American
Odeta Kushi - Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, today's topic may sound a little familiar. As an economist, you should be able to FOMC what we will be talking about care to take a guess.
Mark Fleming - Hi, Odeta.Very subtle. What everyone else is talking about, of course, the Fed.
Odeta Kushi - Right you are. Who says economists can't forecast correctly. But I digress. We won't just be talking about the Fed, but specifically how the Fed can, and how it cannot, impact the housing market. And we'll also take a couple of trips down memory lane. But, first a recap of January's FOMC (Federal Open Market Committee) meeting. Can you give us a little summary?
Mark Fleming - Sure. So everyone sort of knew that this was coming in January. I don't think that was a surprise. But there's nothing like actually hearing it from our friend JP. Chairman Powell indicated, actually quite strongly as Fed speak goes, that the Fed could begin increasing, could, would, probably, will, begin increasing short-term interest rates in March. And I intentionally say increasing, because all indications are that it would be the start of multiple rate increases this year. And asset purchases also are likely to hold in March. In other words, that quantitative easing that's been going on will have been tapered, past tense, as they say. And wait, there's more. The Fed also released a paper, because that's how wonky economists likes to do things, outlining the principles to start significantly reducing the bond holdings on its balance sheet without indicating a specific timeframe. My teachers always told me, when you're forecasting, forecast what or when, but don't do both. And those Fed economists know that too. And here, I have to quote a Fed statement because it's particularly important to the housing market. So here goes in my best Fed tone. 'The committee intends to hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.' End quote. They're talking about us, the housing sector. Their quantitative easing, the purchases of mortgage-backed securities, is the allocation of credit across our sector of the economy.
Odeta Kushi - That's right, I really enjoy your Fed voice, by the way. Recall that asset purchases are part of a monetary policy strategy known as quantitative easing or QE. QE means that the Fed makes large-scale purchases of financial assets, like government bonds and mortgage-backed securities (MBS). After the Great Financial Crisis, purchases of MBS were critical to getting the housing market back on its feet. The Fed's purchase of MBS increased demand at a time when investor demand was faltering, which in turn helped push mortgage rates down. This type of QE helped homeowners lower monthly payments and encouraged investment in housing. Now, when the pandemic began, the Fed took a page out of its 2008 playbook, and once again began to purchase approximately $120 billion worth of assets each month $80 billion of Treasuries and $40 billion of MBS to keep those long-term interest rates low. But, now the Fed wants to reduce their balance sheet. Does that have some implication for mortgage rates?
Mark Fleming - Odeta, is this making you a little uneasy?
Odeta Kushi - Yet, somehow I knew this joke was coming. And yet still. But, yes, it does make me a little uneasy.
Mark Fleming - Okay, it does indeed have implications for mortgage rates. But first, we have to clear up a common misconception about how the Fed influences mortgage rates. The Fed raising rates, as we like to say is referring very specifically to raising the Federal funds rate. What is that you ask? Okay. That is the rate that the Fed sets for banks to charge each other when lending cash overnight to each other from their reserves. That doesn't sound much to me like having anything to do with a mortgage rate of lending money for many years to a home buyer. And that's because it doesn't have anything to do with that. Changes to the Federal funds interest rate does impact short-term rates. Think credit cards and car loans. And an increase in the Federal funds rates could indirectly lead to an increase in mortgage rates because you're basically saying, 'Hey, look, rates are going up across the board and we need to do it at the short end' as they say. But that influence is neither causal, nor predictive. And that's a very economic-y sounding statement, isn't it?
Odeta Kushi - It is. It's giving me some flashbacks to early Econ classes when you're told repeatedly that correlation is not causation. Alright, so this increase in the Federal funds rate may impact your credit card API, but not necessarily your mortgage rate.
Mark Fleming - Right. Instead, things like foreign demand for long-term safe assets, such as the 10-year Treasury bond and other macroeconomic indicators generally drive the influence of why people want to buy long yielding bonds, for example. And that's what really is more influential in determining mortgage rates. The long-end of the yield curve, as they say. But, and this is a pretty big but, if the Fed buys mortgage-backed securities directly, then that's about as causal and direct as it gets because they're intentionally trying to influence mortgage rates downward. Therefore, discontinuing buying those MBS, and then selling mortgage-backed securities at some time in the future that they have not indicated exactly when yet, is intentionally pressuring mortgage rates up. This is "quantitative uneasing," and that matters directly to the housing market.
Odeta Kushi - I want to focus on something you said even if the Fed is directly and causally influencing mortgage rates. More than just economics matter. Political events play an important role in impacting the long end of the yield curve and mortgage rates. So I dug up some examples when mortgage rates moved, and it had very little to do with Fed action. One of the largest shifts in the 30-year fixed mortgage rate since the end of the Great Recession occurred following the 2016 presidential election, the week after the election, mortgage rates increased by nearly 40 basis points. Another example is in the weeks following the Brexit vote in the UK on June 23, 2016. U.S. Treasury bond yields declined by 29 basis points and produced a 15-basis point decline in mortgage rates. Another example is the steady decline in long-term rates since the beginning of 2019, which was partly due to uncertainty around the outcome of US-China trade tensions. And, as an economic example, at the onset of the pandemic, economic uncertainty caused investors to rush to bonds, pushing the 10-year Treasury to its lowest level in 150 years at the time.
Mark Fleming - A 150 -year historic low. That's impressive. But, back to the Fed. One can see the Fed's impact on the housing market through quantitative easing. It has impacted the 10-year bond yields at times in the past and, therefore, mortgage rates. For example, in 2013, mortgage rates increased in response to the Fed's announcement that it would taper its quantitative easing at the time. Remember, the taper tantrum. Similarly, between 2017 and 2018, when the Fed was reducing its balance sheet yet again, the 10-year Treasury picked up and the 30-year, fixed-rate mortgage followed alongside it, maybe less a tantrum, but tapering nonetheless.
Odeta Kushi - So let's discuss what this really means for the housing market. Mortgage rates typically follow the same path as long-term bond yields, which are expected to increase due to higher inflation expectations and an improving economy. And, as we focused on in this episode, Fed tightening, specifically, when the Fed embarks on quantitative uneasing it is more likely to result in higher mortgage rates. Now, the housing market faces a severe supply-demand imbalance, which has resulted in red-hot house price appreciation over the course of 2021. Can the Fed do anything about that?
Mark Fleming - Not really, I mean, supply side is just not the purview of the Fed and monetary policy. And, in fact, rising mortgage rates may even make the supply situation worse. Remember, Episode 28 at the end of last year, where we talked about the rate lock-in effect on the decision to sell. When rates are higher, it will cost you more per month to proverbially buy your own home back from yourself because of that higher monthly mortgage payment due to the higher rate.
Odeta Kushi - And who would do that, right?
Mark Fleming - Ah, yes, who would do that? Right? You and I seem to assume that we're all economically rational actors, right, Odeta? Yeah, like Spock. Like Spock. Maybe we're more like Homer Simpson. But, if we are more like Spock, then higher mortgage rates, holding income constant, reduces consumer house-buying power, and any financial incentive to sell.
Odeta Kushi - Yeah, we discussed this in our latest RHPI report, where we found that if mortgage rates reached 4%, compared with a rate of 3.1%, house buying power would fall by $52,000. Of course, that's assuming that we maintain the same income, and we do not expect incomes to remain flat as the labor market faces its own supply-demand imbalance, which will result in higher wages. Rising wages will offset some of the affordability loss from rising rates, but higher rates might cool some of the double-digit house price growth that we've been experiencing in the housing market. Even so, millennial-driven demand for homes against a limited supply of homes for sale will continue to keep house price growth positive. Alright, well, that's it from us today. Remember, while the Fed may be making us all a little quantitatively uneasy at the moment, there's a lot more that influences mortgage rates than the Fed alone. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at email@example.com. We love to hear from our listeners. And be sure to subscribe on your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.
This transcript has been edited for clarity.