Mortgage rates are strongly linked to the health of the U.S. economy. So, who better to consult about where both are headed than an economist who works in the housing industry? First American Chief Economist Mark Fleming spoke with Dodd Frank Update about his perspective on what the foreseeable future holds for the housing market in the wake of the presidential election.
Fleming said his projection for the long-run mortgage rate between 5 1/2 and 6 percent is slightly more bullish than the one expressed by Mike Fratantoni, chief economist at the Mortgage Bankers Association (MBA), during the organization’s 2024 annual conference in Denver.
He broke down his “simple back of the envelope math” for calculating that figure, adding context by noting while Fratantoni’s projection of long-run mortgage rates in the range of 6 percent is qualitatively about the same and both are based on figures provided by the Federal Reserve for the federal funds rate, 10-year Treasury average and relevant historical data.
“I say that because the Fed is essentially suggesting that the long-run federal funds rate is 3 percent and you assume half a percent or a little bit more for a 10-year Treasury rate on top of that,” Fleming said. “So, you’re talking about a 10-year Treasury rate slightly below 4 percent, and then you add 200 basis points (bps) for the mortgage spread, which is a little bit more than the historical average of 170 bps, but certainly down from the elevated level of 250 bps.”
The result is somewhere between 5 1/2 and 6 percent, he said. Even more interesting than the result will be to see the path the economy takes to get there over the next 18 to 24 months.
“Consider the Fed’s own September projections,” Fleming said. “It’ll be mid-2026 before we settle into what we think the long runway will be. A lot of things can happen between now and then.”
There are plenty of variables to consider when projecting mortgage rates or interest rates, and Fleming noted the Fed has adjusted its federal funds rate projection just within the past few months. In June, the Fed predicted the federal funds rate would be at 2.8 percent by 2026. In September, they upped it to 2.9 percent. What these projections hinge on is the “R-star rate,” also known as the neutral rate of interest – the short-term interest rate that would occur when the economy is at full employment and inflation is stable.
The half-point reduction to the federal funds rate in September represents a significant step toward setting the stage for improved housing affordability and signaled the Fed’s commitment to monetary easing after years of tightening. Fleming said he wouldn’t expect the Fed to flip back unless inflation flared up again. However, monetary tightening can happen without direct action from the Fed.
“If the inflation rate continues to decline, that is essentially tightening, because real rates are getting higher, so you don't have to raise rates to still tighten monetarily as long as inflation continues to cool,” he said.
Fleming described monetary tightening/easing and quantitative tightening/easing as essentially two tools that can be used to achieve the same result. The Fed’s reduction in rates represents an example of monetary easing, while its practice of allowing bonds to roll off its balance sheet without repurchasing them represents an example of quantitative easing.
Although the labor market has been cooling, Fleming noted it is still strong and wage growth has been healthy as well, registering at about 3 percent on an annualized basis. But there is an irony that comes along with both of those facts.
“There’s still a fair amount of strength in the labor market. That’s almost, in a way, an odd concern in this upside-down world,” Fleming said. “Good economic news, strong economic growth and strong labor markets are seen as risks to getting inflation under control. It’s supposed to be the case that if you tighten monetary policy by so much, and as quickly as has been done, that we should have had a recession by now. But we haven’t.”
Despite this observation, Fleming does not think there is significant risk of a recession in the near future – at least, not one caused due to monetary policy.
While a recession would likely cause the Fed to cut rates more quickly, there is more risk that government spending patterns may push rates higher, or at least prevent them from falling to the Fed’s long run projection. Independent projections indicate that both 2024 presidential candidates’ policy proposals will significantly add to the deficit.
“The last time we ran a budget surplus was in the late 1990s, so excess spending is a bipartisan issue,” Fleming said. “Based upon policy plans articulated by both presidential campaigns, both would add significantly to the deficit and the overall debt.”
It’s important to note that the implementation of both plans will largely hinge on whether the new administration can get buy-in from Congress and whether the tax cuts passed in 2017 are renewed or are allowed to expire in 2025 as scheduled, he noted.
“By not letting them expire, essentially, that would add to the debt, even if you did no additional spending than the current projected spending level, because you’re not getting the tax revenue that was going to be expected if you allow the cuts to expire,” Fleming explained. “But, essentially, the congressional majority under either administration would be required to change the laws so they would not expire. But if they can do that, then either one is basically keeping the vast majority of the temporary tax cuts from 2017.”
He then addressed the likely questions on the minds of mortgage professionals and borrowers about how these estimated spending plans may impact mortgage rates and risk premiums.
“It’s kind of like the existential bond question. As an investor, you don’t really care if you believe that the U.S. government is good on its word to pay you back right now,” he said. “There are examples of other countries – Argentina, Greece, Italy – where investors decided that the debt-to-GDP ratio was getting too high, and they basically pulled back and created an environment where the bonds couldn’t be sold or couldn’t be sold at a good price. Essentially, investors started requiring a much higher yield to compensate for the risk of repayment.”
With this in mind, the question Fleming will be looking for an answer to is whether U.S. bond investors will react in any meaningful way to administrative spending by the U.S. government in this election cycle.