Mortgage originators thrive on low interest rates. What could drive rates back down to or below where they were in 2016?
Oddly enough, the answer is that the Federal Reserve might believe that inflation is too low and needs to be kept near 2%. The irony is that the compulsion to keep inflation from falling much below 2% could cause mortgage rates to fall to historic lows. If that seems irrational, it’s not. The Fed has a certain amount of influence on the U.S. economy. Its underlying purpose is to provide liquidity and prevent bank runs — where depositors suddenly withdraw money en masse — that could seriously harm the economy.
Since bank runs do not happen, the Fed does other things, some of which can significantly affect the mortgage industry. The Fed is chartered by Congress “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” To do this, the Fed should aim to bolster the middle class, which would in turn benefit the mortgage industry as well as the overall economy.
Influencing the economy
The Fed accomplishes its chartered goals through monetary policy, which consists of controlling the money supply and regulating short-term rates. In addition, one should not underestimate the more subtle manners in which the Fed has influence.
The Fed chairman and members have their speeches regularly reported and parsed as if they were oracles. Generally, what comes from this are indications about future rate policy and plans for where monetary supply is going. Even though it is the case that the lack of a sustainable fiscal policy is probably more important, the Fed rarely criticizes fiscal policy, instead remaining as apolitical as possible.
During the Great Recession, the Fed lowered the overnight rate to 0.25% and kept it there for six years. It also increased the money supply by about $6 trillion over 10 years. The only direct effect the Fed has on mortgage rates is that changes in the ovenight rate affect the prime rate, which is used to determine the rate on most home equity lines of credit, or HELOCs.
It’s an incorrect assumption that Fed hikes tend to move fixed-rate mortgages in the same direction. The correlation between the two is relatively small. Long-term rates move according to the perception of inflation. The Fed did help lower mortgage rates, however, when it bought securities from the government-sponsored enterprises (GSEs) during the last recession in a monetary policy called quantitative easing.
Concerns about recession
Faced with an ultra-low Fed funds rate and an economy many thought overdue for recession, the Fed began increasing the overnight rate. The main purpose was to create room to lower the rate when a recession eventually happened.
In 2019, the Fed is in a position that it cannot increase rates for fear of inciting recession. Its policy regarding money supply changed earlier this year as it realized that a reduction in money supply (quantitative tightening) might cause recession. Fed Chairman Jerome Powell said this past June that “we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2% objective.”
It is the last phrase that is the key. Although the thinking is that inflation is a problem when it is too high, what the Fed chairman may have been pointing out was that deflation is a more serious problem than inflation. In fact, what the Fed did shortly after Powell’s statement was to lower the federal funds rate.
Fears about deflation
If deflation occurs, prices of goods and services fall over time. Cash would increase in value. Debt, which was no big thing in times of inflation, might prove devastating.
Real interest rates (the nominal rate adjusted for inflation) would rise and loan defaults could occur. This might create chaos for banks. Debt-heavy companies might feel pressure to cut wages and salaries. People with mortgages might not have incomes if their jobs disappeared.
With deflation, one might curse the mortgage originator who got them a 4% fixed-rate loan. Each month, the real value of that fixed number of dollars would increase. The value of homes would decrease. Why would people make their mortgage payment? From mid-2006 to mid-2009, home prices fell by an average of 10% per year and big chunks of the overall economy also declined.
Deflation offers little incentive to invest in large purchases. Why should consumers buy a house, a car or anything expensive if it will cost less next year? Deflation would reduce discretionary spending, hurt jobs and, in general, wreck the economy. Deflation is the enemy of debt. Deflation would hurt individuals, municipalities and states that have debt, as well as the Treasury Department.
The threat to the banking system may well be why the Fed is concerned about deflation. The Fed’s primary purpose is to protect the banking system. Illiquidity in banking causes serious damage to the economy. If banks stop lending, the economy greatly suffers. And although the Fed’s deflationary nightmare is not likely to occur, concern is justified because the damages from deflation are extreme.
Misguided monetary policy
If the Fed indeed fears deflation, it will go back to an accommodative monetary policy, meaning a lower overnight rate and increased money supply. The best solution would be to do something to increase consumer spending and prevent deflation.
Although most discussion of a new round of quantitative easing has assumed that the Fed would once again become a net buyer of Treasury debt, purchasing Treasury debt supports an unsustainable fiscal policy. It does not help individuals and it does not address deflation.
The Fed purchasing Treasury debt is akin to a teenage boy (Congress and the administration) who thinks he can get away with something because his parents (the Fed) will cover his mistakes. Recently, there has been discussion of “modern monetary theory,” which essentially means that the deficit should be constantly monetized. The Fed certainly has the ability to monetize debt by increasing money supply through Treasury-debt purchases on the open market. Having the Fed purchase Treasury debt, however, discourages fiscal sustainability.
Why seek a balanced budget if debt can be monetized without consequence? Although it is true that massive quantitative easing starting in 2008 did not seriously hurt the foreign-exchange value of the U.S. dollar, that was partially because many other nations also increased their money supply. It would be irresponsible to assume that the U.S. could get away with that again.
“ Mortgage originators should advocate for the Fed to devote most of any quantitative easing to purchasing mortgage debt rather than Treasurys. ”
Advocating for a solution
Purchasing Treasury debt will not prevent deflation because it does not induce more demand from consumers. In order to prevent deflation, consumer spending must be increased. Instead of buying Treasury debt, the Fed should increase money supply and prevent deflation by purchasing Fannie Mae and Freddie Mac securitized paper, thus driving down 30-year conforming mortgage rates to 2.5%.
What’s the benefit? The savings that borrowers see would likely go to increased spending. This is more beneficial than having the Fed increase money supply by purchasing Treasury debt. If the Fed purchases conforming loans, the benefit goes to middle-class homeowners — a group of people more likely to spend the savings, benefit the economy and prevent much-feared deflation. Purchasing Treasury debt supports unsustainable fiscal policy, does not help individuals and does not address deflation.
Reduced spending on mortgages can go to one of three places: increased consumer spending in other areas, increased savings or paying off debt. Increased spending has an immediate effect, while increased savings and debt payoffs have delayed effects.
If the Fed returns to a policy of purchasing Fannie and Freddie securities, it is imperative that any politically motivated attempt to lower the GSEs’ lending standards is resisted. A mandate from the U.S. Department of Housing and Urban Development that the GSEs lower their lending standards is what led to their conservatorship.
Mortgage originators should advocate for the Fed to devote most of any quantitative easing to purchasing mortgage debt rather than Treasurys. Having the Fed purchase GSE securities increases the money supply, which should increase all types of lending. This gives homeowners more discretionary spending, encourages gross domestic product and jobs growth, prevents much-feared deflation and has a built-in means of later reducing the money supply.
Unlike Treasury debt, it is not taxpayers who have to pay the interest, but homeowners. This dedicated cash flow provides a ready-made solution to reduce the money supply as principal payments are made.