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Mortgage interest rates have been more or less declining over the past four decades from a peak of 18.3% in October 1981 to a bottom of 2.7% in July 2021. This was mostly driven by a Federal Funds Effective Rate that dropped from 15.1% to 0.09% over the same timeframe. During the past decade, the Federal Funds Effective Rate was essentially just above 0% with the exception of a short period when the rate gapped up 1% to 2% from 2016 to 2020.
During this period of a next to zero Federal Funds Effective Rate, the Fed realized that it could do nothing to influence policy by lowering this rate since they were constrained by the “zero lower bound.” Thus, in March 2020, they adopted a policy of Quantitative Easing (QE) or purchasing assets to increase liquidity in the financial system to drive mortgage rates down further.
Interestingly, Economists were warning the Fed in mid-2021 that their QE policy risked inflation because the central bank was printing too much money which was met with skepticism by the Fed. The Federal Open Market Committee in June 2021 said that the risks to inflation were weighed to the upside but did not slow the pace of bond buying. By Sept 2021, there was strong upward pressure on inflation with it rocketing up to 5.4%, but the Fed kept up the pace of QE acknowledging inflation was “elevated” and calling it “transitory.” It is still to this day unclear why the Fed felt obligated to keep its foot fully on the gas when unemployment clearly was plummeting from 14.7% at the start of the pandemic to 4.8% in Sept 2021 and inflation was surging higher. This is especially true for effects which are known to lag their stimuli.
Finally, in November 2021 with inflation at 6.8% did the Fed begin to modestly slow its QE and by March 2022 with inflation at 8.5% did it finally stop QE and raised the Federal Funds rate by +25 bps. This then has continued to our current effective rate around 5.1%. Interestingly, from March 2022 to today, there have been calls to stop the rate increases because “inflation has been tamed.” Likewise, there have been prognostications that mortgage rates will get back to 3%. Both are false in the short to medium term. The Fed has kept its laser focus of continuing to raise rates until all inflationary pressures are reduced. They were successful in cooling the inflationary pressures of housing which went from an annual 17.5% increase in 2021 to 2.8% in the last 12 months. However, though unemployment is still very low, cracks are starting to appear in the labor market with upward wage pressures now slowing significantly. These are the first signs that unemployment will start to drift upward, and the Fed can then realistically begin to discuss a slowing path of rate increases or ultimate discontinuation of rate increases as many of their objectives will have been achieved. Veros is forecasting that the unemployment rate will increase from its current 3.5% to 4.0% during the next 12 months.
However, the biggest change that has been somewhat overlooked is that the Fed now finds itself back with its historical power where it can use federal funds rate adjustments up and down to implement monetary policy. That is the way that the Fed should operate. It is suspected that once they realize they have a powerful new tool that they haven’t realistically had for a decade or more, the Fed will be reluctant to relinquish it again. They have their mojo back!
Chief Economist and SVP of Analytics