The Federal Housing Finance Agency (FHFA) reported that mortgage rates on purchases of newly built homes continued to climb in April and additional evidence from Freddie Mac indicates that mortgage rates more generally rose in May as well. However, average mortgage rates have moderated over the first week of June.

Mortgage rates reported by Freddie Mac are above the most recent low established in September 2017. The increase since then largely reflects higher short-term rates, which are most responsive to traditional monetary policy. Despite the increase in the 3-month Treasury bill rate, and the federal funds rate, these rates remain negative in real terms, that is when adjusted for consumer inflation.

Negative real short-term rates indicate that both the returns on investments at this horizon and the interest rate associated with borrowing over this period are below the growth of consumer’s overall costs. If the federal funds rate rose to a range of 1.75 and 2.00 percent in June, which is widely expected, then the real rate could increase to zero. Despite the possible improvement, this level suggests that the underlying strength of the economy remains historically very low.

The FHFA reported that mortgage contract rates on purchases of newly built homes rose 11 basis points to 4.44 percent over the month of April. Since reaching 3.93 percent in October 2017, mortgage rates on newly built homes have climbed 51 basis points. Information provided by Freddie Mac, a more commonly used metric, indicates that mortgage rates rose in May as well. According to Freddie Mac, mortgage rates rose by 12 basis points to 4.47 percent. Since falling to 3.81 percent in September 2017, mortgage rates compiled by Freddie Mac have risen 79 basis points. However, weekly data provided by Freddie Mac indicates that mortgage rates have fallen over the first week of June, settling at 4.54.

A deeper assessment of mortgage rate components indicates that rates are rising because of a higher short-term rate. Over the month of May, the higher short-term rate, which tracks the federal funds rate closely, was largely reflected in a higher real yield, while inflation compensation, a reasonable measure of 10-Year inflation expectations, ticked up slightly. In addition, the mortgage risk premium was also muted over the month. One interpretation of these changes is that expectations that the Fed will continue to tighten monetary policy because the economy is relatively stronger is influencing both the short-term rate and the real yield on the 10-Year Treasury Note, which tracked the economy’s potential growth prior to quantitative easing.

Mortgage rates have been rising since September 2017. The increase in mortgage rates largely reflects an 85 basis point increase in short-term rates, which are reflected in expectations of faster inflation and a higher real yield, and was only slightly offset by a shrinking yield curve. Meanwhile, the risk premium has been unchanged over this period. One interpretation of these dynamics over the full September 2017-May 2018 cycle is that mortgage rates are climbing because the Fed is signaling that the economy is improving and the improvement in the economy’s performance is being reflected both in expectations of faster inflation and stronger potential growth, but, the risk of a recession approximately one year away may have risen modestly.

A previous post illustrated the importance of the 3-month Treasury bill rate in the determination of longer-term mortgage rates. Currently, short-term rates are positive and rising. However, in real terms, that is adjusted for inflation, short-term rates remain negative, conditions generally in place since late 2007. In other words, the return on short-term rates is not keeping up with changes in general consumer prices. Alternately, the cost of short-term borrowing is less than overall inflation.

Despite the rate tightening currently underway, real short-term rates remain negative. Currently, the federal funds rate is at a range of 1.50 and 1.75 percent, the 3-month Treasury bill rate is 1.95 percent at the time of this writing reflecting the expectation that the federal funds rate will rise to a 1.75 to 2.00 percent range, but consumer inflation was last recorded as 2.0 percent in April. Moreover, if the federal funds rate were to rise to a 1.75 to 2.00 percent range, then, using the top end of this range, the real federal funds rate would be zero. However, if inflation were to accelerate, say in response to the fiscal stimulus under tight labor market conditions, then real short-term rates, including the federal funds rate, would remain negative for an additional period of time.

ἰ = r* + ∏ + [.5 * (∏ – 2%)] + [.5 * (Y_Actual – Y_Potential)]

ἰ = r* + ∏

One reason this is important is because of its implication for the underlying strength of the economy. The first formula above is a basic Taylor Rule which relates the federal funds rate, ἰ, to the underlying strength of the economy, r*, inflation, ∏, inflation relative to its 2 percent target, (∏ – 2%), and the output gap, (Y_Actual – Y_Potential), the difference between actual GDP and its potential.

Following the update to potential GDP by the Congressional Budget Office in April, actual GDP and its potential are now nearly similar, indicating that the difference is near zero. At the same time, consumer inflation is 2.0 percent, meaning that the difference between it and its target rate is also zero. As a result the Taylor Rule is reduced to the second formula, the underlying strength of the economy, r*, and inflation, ∏.

Financial markets widely expect the Fed to raise its key policy rate to a range of 1.75 percent and 2.00 percent at its June meeting. Using the top end of that range indicates that the federal funds rate is equal to consumer inflation, which is also 2.0 percent, indicating that r*, or the underlying strength of the economy, is zero. Over the shorter-term, the underlying strength of the economy may have improved, but longer-term, estimates of r* suggest that the underlying strength of the economy has been falling and still remains very low.