In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the mysterious metric that moves mortgage rates – the neutral rate of interest – and what it is signaling for the housing market heading into 2025.
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“Let's say this whole thought exercise comes to fruition, that we see inflation continue to cool, and the economy and the labor market weaken enough to warrant the rate cuts that the Fed has outlined in their projections. These rate cuts start to move us towards a neutral rate, and mortgage rates ease towards the high fives by the end of 2025.” – Odeta Kushi, deputy chief economist at First American
Odeta Kushi - Hello and welcome to episode 102 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. Today we're going to be talking about something unobservable.
Mark Fleming - Hi, Odeta. We're a little past Halloween, but this sounds very spooky. What are we talking about here? Tooth fairies, the Abominable Snowman, Bigfoot. What is it?
Odeta Kushi - Very close. Well, I mean, not at all. We're talking about the unobservable, the elusive, the mysterious, natural rate of interest.
Mark Fleming - Wow, that is anti-climactic.
Odeta Kushi - Oh, come on, the natural rate of interest is quite interesting.
Mark Fleming - I won the pun war last time around. Are you sure you want to get into this?
Odeta Kushi - You absolutely did not. We tied the last pun war, but it's probably for the best that we don't get into another one. The other great and topical thing about the natural rate of interest is that it can tell us a little bit about where mortgage rates may be headed.
Mark Fleming - All right, you did get me on this, since it's also known as r-star, I'm up for little stargazing. Care to trick or treat me to an explanation of what the natural rate of interest is?
Odeta Kushi - Oh, my goodness. Well, the natural rate of interest is kind of like a sweet spot for the economy. It's the interest rate that helps keep things balanced when the economy is healthy. It's the rate where inflation is under control and the economy grows at a steady pace without overheating or slowing down too much. But it's not set by a bank or government. Again, it's theoretical, not observable.
Mark Fleming - I like to think of this celestial concept as the real or inflation-adjusted short-term interest rate at which monetary policy is neither expansionary nor contractionary, but – yes, you guessed it – just right. It's not just mysterious because it's difficult to estimate, but also for its many aliases. It's also called the natural rate, the neutral rate, or my favorite that I talked about just a second ago, r-star in our economics notations. The asterisk is often used to denote an optimal or long-term value, hence r-star.
Odeta Kushi - So, we're aiming for neutral. Even in the September Fed meeting when the FOMC voted to lower the federal funds rate by 50 basis points to a target range of four and three quarter percent to 5%, Chairman Powell said in his statement, and I quote, "This recalibration of our policy stance will help maintain the strength of the economy and the labor market, and will continue to enable further progress on inflation as we begin the process of moving toward a more neutral stance." Right now, our interest rates are above what economists believe is neutral, theoretically restraining growth in order to slow inflation down.
Mark Fleming - Well, theoretically, this begs the question, how do economists determine what the neutral rate is?
Odeta Kushi - Ah, well, because it's so difficult to derive. There are lots of different estimates. Some people look to the FOMC summary of economic projections to gauge where FOMC participants believe the neutral rate is, focusing on meeting participants projections of the long-run level of the federal funds rate. So, in the September projections, the longer run rate was 2.9% and the Fed maintained its long-run inflation projection at its 2% target, which implies a neutral, real rate of interest, or r-star of 0.9%.
Mark Fleming - But, as we've discussed in previous episodes, the Fed projections don't necessarily have the best track record of accuracy.
Odeta Kushi - That is true. Well, if you don't trust the Fed projections, you could look at market-based estimates of the neutral rate of interest, like the Treasury inflation protection market.
Mark Fleming - Or our favorite way, you could look at fancy econometric models to try to estimate the neutral interest rate.
Odeta Kushi - To be clear, it's our favorite because we love econometrics, not necessarily because these are more accurate. These models have different specifications, and their estimates will vary, but they also have wide error bands and are prone to revisions. There's been plenty of critiques of these models. I highly recommend a recent analysis from housing economist Tom Lawler, who walks through some of these models, and he ultimately concludes...Another quote here..."So net, in my opinion, it would appear as if the neutral, real interest rate is probably somewhere in the 1.75% to 2% range. If the inflation rate were at, say, 2.5%, then the neutral nominal interest rate would be 4.25% to 4.5%. While if the inflation rate were 2%, the neutral nominal interest rate would be 3.75% to 4%." So, alright, there's another estimate that is significantly higher than the Fed's. But, what moves this neutral rate around? And what does a neutral rate in this range mean for mortgage rates?
Mark Fleming - Well, I'm going to take the first one here. I can be crystal clear on this one. Lots of things move the neutral rate.
Odeta Kushi - Wow. Truly amazing. Great.
Mark Fleming - I know, mic drop and I'm out,
Odeta Kushi - You're good.
Mark Fleming - But more seriously, in the long run, okay, let me take a deep breath here. In the long run, the neutral rate of interest is determined by factors like productivity, because that influences the production capacity of the economy, more output per worker. Government spending, because that also can influence economic output. Demographics, because the higher the number of working-age individuals, the more productive capacity the economy has. Demographics also influences the supply of, and demand for, savings. The older the population, the higher the stock of savings, which firms need to make new investments, which again influences the productive capacity of the economy. These firms need households and other savers, not just domestically, to supply the capital to finance the economic capacity investments that they're making.
Odeta Kushi - Right. So, the neutral rate of interest is the price for savings, which is determined by the supply of savings and the demand for savings, or investment. Factors such as productivity growth, demographic trends, demand for safe assets and government debt all impact that neutral rate, essentially anything that either decreases or increases the capacity for economic growth, because r-star is the rate that is aligned with being neither inflationary or deflationary with that growth capacity.
Mark Fleming - Prior to the global pandemic, the neutral rate was historically low. This was not contained to the U.S., as the trend was similar for other advanced economies, including the United Kingdom, Canada and the Euro area. One main reason, you might ask? Global graying, the aging of demographic populations across the globe, has resulted in excess savings relative to reduced demand for capital investment caused by slower productivity growth. The effect on r-star in the U.S. was further amplified because the U.S. serves as a safe haven for that global excess savings and increases the savings glut domestically. In other words, all the savers globally want to invest here.
Odeta Kushi - And the result, the price of capital, the neutral rate of interest was very low in the U.S. But in today's environment, many people believe the neutral rate is higher. Some believe that the resilience of the economy to higher fed funds rate implies that the neutral rate must be higher.
Mark Fleming - Couldn't it also be the case that the economy is not as sensitive to interest rates, though?
Odeta Kushi - I guess it certainly could. But there are other reasons people believe r-star could be higher or headed higher. For example, more productivity from investments in AI and investments in green technologies. Faster productivity growth would boost returns on investment, increase economic capacity and drive demand for all that excess savings, hence lifting that neutral rate.
Mark Fleming - Another factor that could be increasing the neutral rate by increasing the demand for savings is the U.S. federal government deficit. The fiscal deficit, as a percent of GDP, is currently 6% today.
Odeta Kushi - But, on the other hand, we still have an aging population, so that actually weighs on that neutral rate. So is the neutral rate heading higher?
Mark Fleming - I feel like on the one hand, on the other hand, I need a third hand. Listeners, I think you get the point. We don't really...get kit?...know what that rate is. And, as we mentioned at the top of the episode, the neutral rate is unobservable and elusive. So, this remains a very academic question. But, in the meantime, the Fed will continue to stargaze and chase that elusive neutral rate.
Odeta Kushi - Well, since we're already speaking theoretically. Theoretically, how can we use the neutral rate to inform our outlook on mortgage rates?
Mark Fleming - Yes, of course, the question on everybody's mind, what is the outlook for mortgage rates. So, first, keep in mind that the popular 30-year, fixed-rate mortgage is loosely tied to the 10-year treasury. We've talked about that a lot. So, let's go through this with a very theoretical back of the envelope example. Assume the nominal neutral rate is 3%. That is 1% real rate, plus 2% for inflation, and, as was recently implied by the market, based upon overnight index swaps. If the market has priced in a 3% federal funds rate in the long run, then the 10-year yield, which is driven by that future path of expected monetary policy, is probably going to be somewhere around 3.5%. Now, we assume, on top of that, that the mortgage spread has a little bit of room for compression to come down from its elevated level of 250 basis points today, to say 200 basis points. Let's make the math easy. Then we just add 2% to that 3.5% and voila...
Odeta Kushi - A mortgage rate of 5.5%. Yes, which is very interesting, because surveys from John Burns Research and Consulting reveal that 5.5% is the magic mortgage rate that can unlock the market.
Mark Fleming - Wait, wait, hold on, our listeners would surely not let me pass up this opportunity for an '80s reference. The Cars, Magic. Okay, everyone sing along.
Odeta Kushi - Please, please don't, please don't sing along. Please. No one encourage this. Moving right along, we got our '80s reference. Check that one off the list. This magic rate, according to John Burns, has remained consistent. According to the study, only 13% of homeowners surveyed said they would accept a mortgage rate between 6.5% and about 7% on their next home, but 47% said they would accept a mortgage rate between 5% and 5.5%.
Mark Fleming - Okay? My graduate advisor when I was in school said either forecast how much or forecast when, but don't do both. So we forecasted how much? When do you think we will hit this magical rate of 5.5%
Odeta Kushi - Well, given this very wise advice, I kind of don't want to answer now, but so you know what I'm going to do exactly. I'm going to look to others. I'm going to look at consensus forecasts in the industry and see what they're saying. And they generally expect rates to end the year at about 6% and then gradually decline in 2025, but still ending 2025 between 5.5% and 6%, and we probably start to get closer to 5.5% percent by 2026, according to those forecasts. So, let's say this whole thought exercise comes to fruition, that we see inflation continue to cool, and the economy and the labor market weaken enough to warrant the rate cuts that the Fed has outlined in their projections. These rate cuts start to move us towards a neutral rate, and mortgage rates ease towards the high fives by the end of 2025. What does it mean for the housing market?
Mark Fleming - Well, mortgage rates falling to the high fives should spur existing-home sales...that's not rocket science...to rise from their current cycle lows, but not by a lot, maybe the mid-four million range.
Odeta Kushi - Progress is good news here, but I suspect the reason you're saying that is because sales activity will continue to be constrained by the rate lock-in effect, keeping sellers who would be buyers on the sidelines and limiting inventory. The latest NMBD Q2 2024 data reveals that 84% of mortgage homes have a rate below 6%. And, while that is down from the peak of about 93% in 2022, it's still very, very high, so that rate lock-in effect will continue to be a limiting factor in the housing market next year.
Mark Fleming - Definitely still with us next year. On the new home side, though, lower rates should ease affordability constraints for those potential buyers, and those lower interest rates on construction loans. And new home sales will continue to outperform the existing market, because big builders, in particular, can continue to offer incentives that entice buyers off the sidelines and buy down those mortgage rates.
Odeta Kushi - And, of course, a more obvious prediction here, if rates come down, mortgage refi activity will likely increase through the end of 2025 as it becomes less expensive for homeowners to access their record levels of equity, whether with home equity loan products or cash out refinances.
Mark Fleming - A forecast no brainer, right there.
Odeta Kushi - Exactly.
Mark Fleming - So another not too hot, not too cold, but getting closer to just right, prediction for the housing market.
Odeta Kushi - Said it before and I'll say it again. We're looking for progress, not perfection, at this point.
Mark Fleming - But I do know one thing that I can predict perfectly, an '80s reference streak that I, for one, forecast will continue well into 2025.
Odeta Kushi - Well, on that note, that brings us to the end of the episode. We hope you learned a little bit more about the mythical metric that moves mortgage rates.
Mark Fleming - Five Ms. Impressive, and you didn't get tongue tied.
Odeta Kushi - That's right. Okay. Well, that's it for today. 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@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.