Many real estate experts have long viewed the Federal Reserve’s interest rate cuts as a lever that could potentially make housing more affordable. Lower borrowing costs will indeed lead to a decline in mortgage rates. However, hoping to see the return of 2% or 3% mortgage rates in the short term is unlikely to be part of the script.
In reality, the Federal Reserve is more likely to maintain the benchmark interest rate at a certain level. Even if they do cut rates, it is not easy for the market to lower mortgage rates enough to significantly impact housing prices. Why is that? Let’s delve into the analysis.
Currently, many believe that high mortgage rates are a result of the Federal Reserve raising interest rates, and they expect that once the Federal Reserve cuts rates, mortgage rates will come down, and then they can buy a house. However, this wishful thinking may not materialize.
There are two main reasons why even if mortgage rates decrease, housing prices may not plummet. The first reason is that the speed of rate reduction may not be rapid. Even if rate cuts begin, there is still a high probability that the 30-year fixed rate will remain around 6%.
Some experts believe that a drop to 5.5% in rates could trigger a buying spree, but U.S. banks argue that the gap between effective rates and current rates is still not significant enough to drive people to purchase homes.
Seth Carpenter, the Global Chief Economist at Morgan Stanley, recently mentioned in a podcast that the U.S. real estate market may not become more affordable anytime soon.
During the Federal Reserve meeting in June, officials indicated a potential rate cut in 2024. Therefore, if the Fed implements modest monetary easing, mortgage rates will also decline, albeit gradually, rather than drastically.
Thus, even if the rate gap narrows, it won’t diminish significantly. In other words, most homeowners in the U.S. still hold onto low rates around 3% to 4%, but there is a high probability that future mortgage rates could surpass 5.5% or even reach 6%. Ultimately, the likely scenario is a slowdown in home price appreciation rather than a complete collapse in prices.
The real estate market tells us that the effects of monetary policy on the housing market are somewhat weaker compared to historical levels, but it’s not that monetary policy is ineffective. Experts at Morgan Stanley believe that while the overall real estate market isn’t at risk of collapse, monetary policy is suppressing economic activity in a familiar manner, slowing down home sales without necessarily lowering prices.
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Real estate experts have been focused on how the Federal Reserve’s interest rate decisions may impact the housing market. However, the Fed doesn’t directly set mortgage rates, and its decisions don’t affect mortgage rates in the same way as savings account or CD rates. Mortgage rates often move in sync with the 10-year Treasury yield.
While the Fed’s policy does establish an overall tone for mortgage rates, lenders and investors closely watch the central bank. Interpretation of the Fed’s actions in the mortgage market causes rate fluctuations, affecting the amount buyers pay for home loans. In 2022, the Fed’s seven rate hikes led to a surge in mortgage rates from 3.4% in January to 7.12% in October. Mortgage rates continued to rise in 2023, temporarily reaching 8%.
In early July, Fed Chairman Powell reported to Congress that recent data showed a significant cooling of the labor market compared to two years ago. The unemployment rate, released on July 5th, has risen for the third consecutive month, reaching 4.1%. Signs of a weakening job market are increasing, putting pressure on Fed officials to decide when to ease monetary policy.
Powell emphasized that cutting rates too early or too much could hinder or reverse progress on inflation. The Personal Consumption Expenditures Price Index (PCE) inflation, which stood at a peak of 7.1% in June 2022, has dropped to 2.6% as of May this year. This data has relieved some Fed officials, indicating a slowdown in inflation after an unexpected rise earlier this year. However, some officials maintain that they need more confidence that this trend will continue before reducing borrowing costs.
However, many economists warn that the slowdown in the labor market could further deteriorate. The number of people searching for jobs for at least 15 weeks in June reached the highest level since early 2022. Finding a job is becoming more challenging, and job searches are taking longer as employment slows down.
The Fed’s current challenge is not only inflation but also a heightened focus on the unemployment rate. Democrats warned Powell on July 9th that delaying rate cuts could pose risks to the economy, leading to higher unemployment, increased housing costs, and a slowdown in manufacturing. Republicans generally agree with these arguments.
Many economists point out that the labor market has significantly cooled, and while alarm bells haven’t rung yet, the trend is heading in that direction. Balancing continued inflation reduction while avoiding a substantial increase in unemployment poses a dilemma for the Fed.
Although the Federal Open Market Committee is unlikely to cut rates at the meeting scheduled for July 30-31, the probability of a rate cut in September remains high. As of July 12, according to the CME Group’s FedWatch tool, there is about a 90% chance of a one-point rate cut.
The speed of rate cuts is crucial. Even if there is a one-point cut or no cut at all, it may not have a significant impact on mortgage rates. As per Mortgage News Daily, the average 30-year fixed rate stood at 6.99% on July 10th, although it has decreased from earlier highs this year, it remains close to 7%.
Fortunately, as of July 11th, the June CPI data showed a year-on-year increase of 3%, down from 3.3% in May. With inflation easing, paving the way for further rate cuts by the Fed and potential adjustments in mortgage rates.
The second reason why rate cuts may not necessarily lower housing prices: Some believe that once mortgage rates drop, sellers may flood the market, leading to a surge in prices – which is not favorable for those looking to buy homes for personal use.
On the other hand, Chen Zhao, Head of Economic Research at Redfin, thinks that a decrease in mortgage rates will bring both buyers and sellers back to the market, potentially accelerating price increases or decreases, depending on who returns with greater intensity. If sellers return more quickly, prices may cool off; however, if buyers re-enter the market faster, prices could rise.
Robert Reffkin, Co-founder and CEO of real estate giant Compass, recently mentioned that a 30-year fixed rate of 6.5% would be satisfactory, but the magical number is 5.9999%, indicating an optimal buying rate for properties.
In essence, the speed of rate reductions might not be swift. When rates approach around 6%, experts recommend it as a good entry point. However, if rates gradually decline this year, it may not significantly impact the housing supply since the gap in rates remains too wide for existing homeowners to be motivated to move.
Moreover, markets with increased supply due to lackluster sales or higher new home inventories have a chance of price declines, especially in areas that experienced overheating during the pandemic and are more susceptible to market corrections.
All in all, it all depends on how quickly the Fed cuts rates. If there’s only one rate cut this year, it may not have a substantial impact on mortgage rates. But if we see strong inflation data again in August, a second rate cut might be possible, leading to a more significant effect on loan rates, possibly approaching 6%; the last time rates were close to 6% was at the end of January 2023.
In the past week since July 5th, mortgage rates have remained around 7%, easing demand for loans, with applications down by 0.2% compared to the previous week, and the refinancing index dropping by 2%.
Looking back to late January last year when rates touched 6%, there were fluctuations in mortgage applications, showing an increasing trend in purchases despite being in the housing market’s off-season.
It’s worth noting that seasonal trends in the housing market are likely to align with rate movements. If rates significantly drop during the off-season, there’s a high chance that this will coincide with the housing market’s slower period, as seen frequently in the past two years. Many experts predict that towards the end of the year, as rates drop and inflation slows, the buying and selling dilemma may intensify entering the holiday season. Individuals will have to weigh personal circumstances and market availability before deciding to enter the market.
Therefore, will rate cuts indeed not trigger a decrease in housing prices? It is still a possibility. It primarily hinges on the scale of the rate cut and its impact on mortgage rates. If the cut is sufficient to attract a surge of buyers and sellers into the market, the prices may not drop. However, if the cut is not significant enough, continuing to strain buyers’ affordability, accumulating a surplus in a sluggish real estate market may eventually lead to further price declines in some areas. ◇