In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss how the Federal Reserve signals potential policy changes on interest rates and the tapering of its Treasury and mortgage-backed securities purchases.
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“So the taper may actually help to bring some balance to the housing market, which by the way, it does need. We recently released our July Real House Price Index (RHPI), which showed that while house-buying power increased by nearly 4% on a year-over year-basis in July, nominal house prices increased over 20%, vastly outpacing house-buying power. So, if rates increase, it will cause some home buyers to pull back from the market, which may result in fewer, or less intense, bidding wars and a moderation of house price gains.” – 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'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, I've got a joke for you. Why can't you hide while wearing polka dots?
Mark Fleming - Hi, Odeta. Hmmm, this is a new twist on how we start our REconomy episodes, but Okay, okay, I'll play along. I don't know. Why can't I hide while wearing polka dots?
Odeta Kushi - Because you'll always be spotted.
Mark Fleming - Um, okay. Please don't quit your day job.
Odeta Kushi - Alright, fine. But the joke is somewhat relevant to today's topic in that they both refer to dots. Because today, and you guessed it...
Mark Fleming - I did?
Odeta Kushi - Isn't it obvious, we're talking about the Fed's dot plot and what the latest dot plot means for the housing market. But first, let's start with what it is. The FOMC or the Federal Open Market Committee dot plot, also called the Fed's dot plot is a chart that summarizes the FOMC outlook for the federal funds rate. Now, four times a year the FOMC publishes a summary of economic projections or SEP. The SEP includes forecasts for where key economic indicators, like unemployment, GDP and inflation, will be. This quarterly release also includes the dot plot, which shows each Fed official's projections for what the federal funds rate will be up to three years and over the long run. The dot plot dots are anonymous, so you don't know which Fed official made which projection. You can check out my Twitter feed @OdetaKushi to see a picture of the most recent dot plot released by the Fed in September. The dot plot is a Fed member forecast, not a policy commitment, but they are closely watched by the financial market because they're viewed as a guide for future Fed monetary policy. So Mark, can you talk a little bit about how the dot plot came to be?
Mark Fleming - I think I first have to acknowledge that we are working with a tongue twister here in the word dot plot. But yes, we love our economic history here on REconomy. But you might be surprised to learn that there's actually not a lot of history here to talk about. The dot plot was invented in 2012, not that long ago, after the global financial crisis and in the hope of providing more, shall we say transparency into Fed monetary policy. If you recall, after the 2008 crisis, the Fed lowered the Fed funds rate to zero. And here's the big one. For the first time ever, the Fed purchased US Treasuries and mortgage-backed securities, what we refer to as MBS. Participating in the bond market directly like this, not only the first time it had ever been done, it was also known as quantitative easing. New tools, less transparency. And financial markets don't like all that uncertainty. When will the fed funds rate go back up? Will they do that before or after stopping quantitative easing? So many questions. Enter the dot plot, more transparency. Well, or now just even more uncertainty? Because it's not a policy commitment, or is it? It's just a forecast. By the way, Fed chair Jerome Powell has said just this summer that the dots are not a great forecaster of future rate moves because it's so highly uncertain.
Odeta Kushi - Ah, yes, the folly of forecasting interest rates.
Mark Fleming - Yes, we try to avoid that task like the plague around here. The Fed regularly reminds us that they are data dependent in making their decisions. And, as we know, a lot can happen with economic and geopolitical events in the future.
Odeta Kushi - Like a pandemic, for example.
Mark Fleming - Ah, yes, like a pandemic, something we did not see coming back in 2020. Investors also compare the dot plots from quarter to quarter to see how the Fed forecast is changing, looking for any information to reduce that uncertainty. And when you hear that the Fed has a more hawkish -- forecasting a higher rates position -- or a more dovish -- forecasting a lower rates position, that's financial market lingo for their perception of the direction of monetary policy from this forecast that we all acknowledge isn't very good. I know bird lovers may disagree, but it would seem in this lingo that hawks are bad and doves are good. But, in the most recent September report, and this is the big news, the Fed indicated a more hawkish tone. Care to explain, Odeta?
Odeta Kushi - Well, so as you mentioned, investors are very interested in the quarterly projections, as rates have been sitting near zero since the beginning of the COVID-19 pandemic. And, the Fed has indicated that rates won't increase, and quantitative easing tapering will not begin, until "substantial further progress" has been made towards its goals of full employment and stable inflation. Yet, the labor market continues to improve, and the Fed has remained consistent in its messaging that the current increase in inflation is largely reflecting transitory factors, as opposed to an expectation for a longer run transition to higher inflation. At the latest Fed meeting, not only did the Federal Reserve signal that it was ready to start reversing its pandemic stimulus programs as early as the end of this year, but dot plots indicated that a rate increase could be in the cards for next year. In fact, nine of the 18 FOMC members expect a rate hike in 2022. That's up from seven in June's Fed projections. Additionally, all but one member is expecting at least one rate hike by the end of 2023. Now, as you've mentioned, and as I will reiterate, the dot plot doesn't have a great record in accurately predicting lift off. For example, projections from the December 2015 meeting showed that the median Fed official expected four rate hikes in 2016, but we only had one rate hike that year in December. And this has nothing to do with the Feds ability to forecast. It's more to tell the rest of us not to rely so strongly on dot plot predictions. So why would the Fed be taking a more hawkish tone, implying a higher likelihood of raising interest rates than the previous June meeting?
Mark Fleming - You can see the irony here. We just said don't pay too much attention to it. But, let's pay some more attention to it. Yes, the Fed is seemingly indicating that they are happy with the progress towards full employment and price stability that we've seen in the rebound since the bottom of the recession, and signaling that the economy will continue to recover, maybe not as fast as we had originally thought, but still strong recovery. But, another way that they've showed the confidence in the economy is by indicating that they may actually not only raise the Fed Funds rates, as indicated by the hawkish dot plot, but, more importantly for us, slow down the purchase of those Treasuries and mortgage-backed securities. In other words, taper that quantitative easing as early as the end of this year.
Odeta Kushi - Well, that has some pretty strong implications for the housing market, as we discussed in Episode 19. And, just a refresher, the Fed is currently purchasing approximately $120 billion worth of assets each month -- $80 billion in Treasuries and about $40 billion in mortgage-backed securities in order to keep long-term interest rates low. Now that the Fed is signaling a slowdown in MBS purchase, is this the end of the housing market?
Mark Fleming - The end, it has to be the end when rates go up from ever-long historic lows. Hardly. Of course not. One of the biggest challenges in the housing market today is how to satisfy all the demand caused by the cheap mortgages because of quantitative easing. This easy monetary policy is why house prices, in part, are continuing to break record growth pace levels. What would we expect when demand is high with a limited supply of homes for sale. If mortgage rates actually rise because the Fed reduces their purchase of mortgage-backed securities by a little bit -- in other words quantitatively taper -- affordability will be impacted and that will cause a little bit of that demand just to cool a little.
Odeta Kushi - So the taper may actually help to bring some balance to the housing market, which by the way, it does need. We recently released our July Real House Price Index (RHPI), which showed that while house-buying power increased by nearly 4% on a year-over year-basis in July, nominal house prices increased over 20%, vastly outpacing house-buying power. So, if rates increase, it will cause some home buyers to pull back from the market, which may result in fewer, or less intense, bidding wars and a moderation of house price gains.
Mark Fleming - Yes, but that doesn't mean a collapse in house prices, or a crash in house prices. Remember tapering alone is not going to fix the supply and demand imbalance that we see in the housing market today. And, as we've talked about before, don't forget that buying home is not just a financial decision. It's also a lifestyle decision. So, even if rates increase modestly, there will still be plenty of demand from all those millennials. You included, Odeta.
Odeta Kushi - Right, me included.
Mark Fleming - ...who will want to become homeowners, looking to move to the suburbs, start a family do all the things that people do at that life stage, regardless of interest rates. Refinance demand, on the other hand, well, that's definitely much more rate sensitive.
Odeta Kushi - You're right, the demographic demand remains very strong. And, not only that, but it's important to note that while rates are widely anticipated to increase -- consensus forecast still puts them at about 3.2% in the last quarter of 2021, which is very, very low from a historical perspective. And part of the reason for that is that while the Fed may begin to taper its asset purchases, there still remains quite a bit of downward pressure on rates from the ongoing uncertainty caused by the pandemic.
Mark Fleming - Yes, uncertainty and the flight to safety. When global investors sense increased uncertainty that flight to safety goes where? Luckily for us, it goes to US Treasury bonds, which causes their prices to go up and their yield to go down. And mortgage rates follow those yields roughly. The 10-year Treasury yield today remains barely above 1.5%, even though inflation is in the 3% or 4% range, depending upon what metric you look at. This is still historically less than 2%. We never saw yields below 2% before the financial crisis, and yet they've been pretty much there the entire time since. So, still lots of downward pressure on the 10-year Treasury yield and mortgage rates, shall we say, by association.
Odeta Kushi - So, there you have it, that Fed's dot plot indicated that rates might be increasing sooner than expected, but it's all dependent on the economic recovery. As long as the recovery remains on track, there is reason to believe that a rate hike may be in the future for 2022. Tapering is likely to happen sooner and that may prompt mortgage rates to rise. But, fear not, it does not mean that the housing market will crash, although we may see some cooling of purchase demand and definitely a cooling of refinance demand. Well, that's it for today. Thank you for joining us on this episode of the REconomy podcast. 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, please follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.
This transcript has been edited for clarity.