In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi examine the latest signals from the Federal Reserve about the direction of interest rates and the potential for rate cuts in 2025.

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Listen to the REconomy Podcast™ Episode 106:

“There's a lot of uncertainty this year, many unknowns related to fiscal policy. But to summarize here, the Fed is signaling that rate cuts this year will be smaller than they previously thought, assuming, of course, the economy evolves as expected. The Fed is really walking a tightrope, balancing the need to support growth without letting inflation reignite.” – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Hello and happy new year. Welcome to episode 106 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, it's our very first episode of 2025.

Mark Fleming - Hi Odeta and Happy New Year to all of our listeners. A new year means, of course, a clean slate and more importantly, an opportunity for me to try for a new record of consecutive 80s references since you and Xander apparently broke my streak on the last episode of last year.

Odeta Kushi - Yeah, I was kind of hoping you had forgotten all about that. Last episode, I made the mistake of breaking our streak of 80s references and my co-host here has made it abundantly clear that he will not let that happen again. So Mark's basically my own personal breakfast club detention monitor at this point. See what I did there?

Mark Fleming - Yes. Okay, that's a step in the right direction, but if I wasn't there then the streak wasn't broken technically, was it? And now you're getting in the act too? I suspect our listeners are now doing the eye rolling. Yet we digress. What's the topic for our first episode of the year?

Odeta Kushi - Mm-hmm. Today we are talking about the thing on everyone's mind, the Fed.

Mark Fleming - Wait, did I just go back to the future? Uh-huh, yep, done and done early. Wasn't the Fed on our mind like all year last year? I'm sure that this won't be the only time this year we'll be discussing the Fed either, so.

Odeta Kushi - Yeah, I think I would bet on that forecast, but I'm excited to discuss the Fed because we haven't really had the opportunity to discuss the December 18th meeting on the podcast yet.

Mark Fleming - Ooh yeah, and it was an eventful meeting, at least as Fed meetings go. So a quick summary.

Odeta Kushi - That's right. That's a good idea. Well, first thing, as widely expected by market participants, the Federal Open Market Committee, or FOMC, reduced its target rate for the federal funds rate by 25 basis points.

Mark Fleming - No surprises there, and that means the FOMC has cut its target range by 100 basis points in 2024.

Odeta Kushi - And despite that rate cut, the market largely saw this as a hawkish rate cut. And there were several reasons behind this. First, the president of the Federal Reserve Bank of Cleveland dissented, voting to keep rates on hold instead. Chair Powell also noted in his post-meeting press conference that the decision was a closer call to cut rates by 25 basis points than it was in the November meeting.

Mark Fleming - And another reason is that the committee made a change to its post-meeting statement. And we read into these changes quite a bit and very closely. There's even a tracker from the Wall Street Journal that updates the statements sort of crossing out what's changed and adding what's changed to every meeting showing those tracked changes.

Odeta Kushi - It's really all about the changes in these statements. And in the November meeting, the FOMC statement mentioned, and I quote, in considering additional adjustments to the target rate for the federal funds rate, then in the December meeting, that line was changed to in considering the extent and timing of additional adjustments to the target range for the federal funds rate. One of these things is not like the other. Back to Sesame Street here.

Mark Fleming - Yeah, and if you weren't careful, you could miss it. These are the nitty gritty details. Indeed, the addition of extent and timing.

Odeta Kushi - Right. And what we all collectively read from that edition was that the FOMC may pause rate cuts in future meetings this year.

Mark Fleming - Say it ain't so! Well, we received some confirmation of that in their FOMC projections. Recall that every quarter the FOMC updates their Summary of Economic Projections, or the SEP as it's called, which gives us a glimpse into how they see key economic indicators evolving like GDP growth, unemployment, inflation, and of course, interest rates. Think of it as the Fed's crystal ball with, of course, some margin of error.

Odeta Kushi - They don't always get it right. In fact, their latest December projections came with a few adjustments from their last September meeting projections. They nudged the GDP growth forecast a little higher and lowered the unemployment forecast for this year. But the core PCE inflation rate, a key measure of price stability, was actually revised up from 2.2 % to 2.5 % for 2025.

Mark Fleming - True, but the real headline here is the interest rates themselves. Back in September, the median FOMC member thought that the Fed funds rate would drop to a range of 3.25 to 3.5 % by the end of 2025, basically implying a full 100 basis points of additional cuts in 2025.

Odeta Kushi - But in this latest update, the median projection has shifted. Now they think a higher range of 3.75 to 4.4 % is more likely. That's only 50 basis points of easing this year, half of what they expected in their last projections in September.

Mark Fleming - That's right. And we should also note that the dots, the dreaded dots in the dot plot for this year were widely dispersed. The most dovish committee member thought that 125 basis points of additional easing would be appropriate this year, while the most hawkish members saw no additional rate cuts, so a wide variation.

Odeta Kushi - I mean, there's a lot of uncertainty this year, many unknowns related to fiscal policy. But to summarize here, the Fed is signaling that rate cuts this year will be smaller than they previously thought, assuming, of course, the economy evolves as expected. The Fed is really walking a tightrope here, balancing the need to support growth without letting inflation reignite. I do not envy their position.

Mark Fleming - Exactly. It's the dual mandate after all. And while inflation has made a lot of progress and the labor market has been remarkably resilient, the Fed is acknowledging that inflation has been a little stickier than they had hoped or anticipated and that they don't want the labor market cooling much further.

Odeta Kushi - But we've noticed that the hires rate has trended lower and while the layoff rate is still low, a depressed hiring rate might eventually lead to higher unemployment. And again, the Fed wants to avoid a job loss recession.

Mark Fleming - Yeah, their base case is still a soft landing scenario.

Odeta Kushi - So just out of curiosity, how did the markets react to the snooze?

Mark Fleming - Cool, calm, and collected, of course, as always. No, of course not. The FOMC decision pushed the stock lower and said treasury yields soaring. was the worst loss for the S &P 500 on the day of a rate decision since 2001. Exactly.

Odeta Kushi - I sense some irony in your tone there. Now that sounds more like it. The probabilities of changes to the Fed rate, as implied by 30-day Fed funds futures prices, indicated there was over a 50 % chance that the Fed would cut rates once or not at all this year. This was the day after the Fed change.

Mark Fleming - That's right. So, in the aftermath of that Fed being hit, and really it was an aftermath, the market expected fewer rate cuts in 2025 than even the Fed revised rate cut suggestion was.

Odeta Kushi - That's so interesting to me. So, you mentioned that treasury yields soared. I have to bring it back to housing here. Does that mean we saw mortgage rates go up after that meeting?

Mark Fleming - And what easier way to do it than with the connector of the 10 year treasury to mortgage rates. We sure did see an increase in the yields and that resulted in mortgage rates creeping back up above 7%.

Odeta Kushi - The industry just can't seem to catch a break with mortgage rates. Even as the Fed has cut rates, mortgage rates have increased. And as a brief reminder here, the 30-year fixed rate mortgage is loosely benchmarked to the 10-year Treasury bond, which again is often known as the risk-free benchmark for financial transactions worldwide. So shifts in global demand for U.S. Treasury bonds cause their price to go up and their yield to change with it. For example, the higher the current rate of inflation and the higher the expected future rate of inflation, the higher the yield that an investor would require to compensate for that anticipated increase in the future cost of money due to inflation. When the 10-year treasury yield rises, mortgage rates follow suit and vice versa.

Mark Fleming - Exactly. The Fed basically said in their projections that the economy will be stronger in 2025. That's good news. And inflation will be sticky. Maybe not such good news. And this lowered the bond market's expectations for future rate cuts to the Fed's December projection, pushing the 10-year Treasury yield up and mortgage rates higher.

Odeta Kushi - Now to clarify, the Fed is still expecting to cut rates this year, just not by as much. So while we believe that mortgage rates will zigzag throughout the year, the trend should be slightly lower as the Fed lowers rates and the policy outlook becomes clear.

Mark Fleming - Yes, more certainty about Fed policy should also allow mortgage spreads to come down a bit. Remember, we've talked about the fact that they're currently and have been elevated. More on mortgage spreads are in our economy episode 71, but our baseline expectation still has mortgage rates above 6 % this year.

Odeta Kushi - Alright, so that's not great news for the housing market because not too long ago, industry consensus had a 5 on the left-hand side of that decimal. But rates aren't everything. Indeed, despite higher rates in November, existing home sales rose nearly 5 % on a monthly basis to the swiftest pace since March. Sure, lower rates would improve affordability, unlock golden-handcuffed homeowners and thereby unleash much-needed supply, and lower financing costs for builders to build more homes.

Mark Fleming - True. Wasn't that supposed to tell us why rates aren't everything here? Because I don't think you did a very good job and I feel like there's a but in here somewhere.

Odeta Kushi - I'm getting to it. What the market needs is mortgage rate stability. It's about having some sense of where they're heading. Think about inflation expectations. If we think inflation is going to be higher tomorrow, we're more likely to spend or invest today to get ahead of those rising prices. But if we think prices are going to drop, we hold off.

Mark Fleming - That's right, and I see what you're saying. If buyers think rates might spike in the future, they rush to lock in the deal. But if there's constant volatility, rates jumping up and down, it creates hesitation. People pause, waiting for the perfect moment that might actually never come.

Odeta Kushi - So I mean, are there any lessons from past history that maybe you can point to?

Mark Fleming - I'm so glad you asked, Odetta. When we compare the current housing cycle to those of the past, we see similarities in demographics, inflation, interest rates that echo the housing market of the 1980s. Exactly. It's like I'm drawn to that decade in every way. But seriously, in the late 70s and early 80s, interest rates soared as the Federal Reserve fought to rein in the great inflation. Sound familiar?

Odeta Kushi - The 1980s?

Mark Fleming - As a result of tighter monetary policy and higher inflation, mortgage rates increased to a peak of 18 % in 1981. Mortgage rates reached levels unseen before or since homes became significantly less affordable and home sales fell. Again, sound familiar? The housing market did rebound from that 1980s peak, but it took some time. Inflation and mortgage rate stabilization were key at that time and are key again.

Odeta Kushi - So mortgage rate stability, even if the stabilization occurs with rates at a higher level, is the key to an eventual housing recovery.

Mark Fleming - Yep. And don't forget buying a home isn't just a financial decision. It's a lifestyle decision. We've referred to these lifestyle factors that drive housing demand as the five D's that is diplomas, diamonds, diapers, divorce, and death. Yes. In life event chronological order.

Odeta Kushi - But with mortgage rates expected to remain elevated and house price growth remaining positive, how is affordability ever going to improve?

Mark Fleming - patience, Padawan, patience. Wage growth, not an 80s reference. Wage growth that will need to outpace house price growth. That's usually how it's done. And we do expect wage growth to remain positive in 2025 and house price growth is anticipated to move generally sideways in low single digit paces of inflation.

Odeta Kushi - my goodness. Okay, so to recap here, the FOMC is projecting that they'll cut rates by 50 basis points in 2025 instead of 100 basis points. Mortgage rates will likely remain above 6%, but even mortgage rate stability will bring buyers and sellers off the sidelines. Anything I'm missing for this year,

Mark Fleming - Exactly. Well, we're going for a new record of 80s references this year, and we're starting strong with three in the first episode alone. Of course.

Odeta Kushi - Of course you counted. Well, we will end on that note. Happy New Year to all and 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 in the future, you can email us at economics at firstam.com. And as always, if you can't wait for the next episode, you can follow us on X. It's @Odetakushi for me and @mFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.