The Fed's Shift in Policy: The Mortgage Industry Is Poised for a Hit from Higher Interest Rates in 2005. Here's Some Insight into the Fed's Thinking as It Reacts to Economic News and Positions Itself to Move Rates Higher in the Months Ahead

By England, Robert Stowe | Mortgage Banking, October 2004 | Go to article overview

The Fed's Shift in Policy: The Mortgage Industry Is Poised for a Hit from Higher Interest Rates in 2005. Here's Some Insight into the Fed's Thinking as It Reacts to Economic News and Positions Itself to Move Rates Higher in the Months Ahead

England, Robert Stowe, Mortgage Banking

THE FEDERAL OPEN MARKET COMMITTEE (FOMC), the arm of the Federal Reserve that sets interest rate policy, earlier this spring set a new course to restore the central bank's monetary policy stance to neutrality. For four years, it has pursued a policy of accommodation in the face of a series of threats to the economy: recession; rising unemployment; 9/11 and its economic aftermath; corporate accounting scandals of 2002 with their market fallout; and worries about deflation in 2003.

With the economy showing signs of inflation since early this year, fears the Fed held previously that prices might fall (deflation) were largely dispelled. Throw in a strengthening economy, rising profits and significant improvements in the number of new payroll jobs, and the FOMC found by its May 4 meeting that conditions suggest it is time to change the course of monetary policy.

In its characteristically brief style, the FOMC stated after its May meeting that it "believes that policy accommodation can be removed at a pace that is likely to be measured."

The key question for Fed watchers and mortgage bankers is how will the FOMC go about charting its course and, in turn, how will that affect interest rates, the mortgage market and the economy? More specifically, what is meant by "measured," and how rapid and how big will be the steps the FOMC plans to take to reach its goal of neutrality?

In July, Sen. Richard Shelby (R-Alabama), chairman of the Banking, Housing and Urban Affairs Committee, asked Federal Reserve Chairman Alan Greenspan to explain further what the FOMC meant by a "measured pace" when Greenspan gave his semiannual report on monetary policy. Characteristically, Greenspan answered in an indirect way that revealed some key elements of his thinking, but also left out considerable detail.

"[I]f we are to maintain the mandate which the Congress has given us to create price stability, mainly for the purpose of maintaining and fostering maximum sustainable long-term growth--because that's our objective--we will do what is required to achieve that objective," Greenspan told Shelby.

Greenspan shed light on this point in his prepared remarks, in which he laid out two potential general scenarios the Fed might follow: one measured and the other dynamic. Here's the money quote: "If economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates."

Or, to paraphrase, the Fed is planning a gradual increase in interest rates, but if conditions warrant, it could become a bumpy ride. And, by the way, the chairman implied, if this approach is necessary, the economy will be strong enough to take a bumpy ride.

The Fed's anticipated gradualist approach to higher interest rates contrasts with its approach a decade ago. Back in February 1994, the markets were surprised by the Fed's interest rate increase that came at a time of accelerating economic growth.

Back then, after the Fed announced a quarter-point rate increase in the target for the federal funds rate (from 3 percent to 3 1/4 percent), the bond market plummeted while interest rates jumped across the yield curve. A series of additional interest rate increases followed as the Fed fought an incipient spike in inflation, pushing the economy into a slowdown that came close to being a recession.

"In effect, they're telling us that it's not 1994 all over again," explains Bob Hormats, vice chairman of Goldman Sachs International, New York. "Back then the Fed thought it was behind the curve. They were worried they had fallen behind and had to catch up. It doesn't seem to believe that now," he adds.

Because the Fed foreshadowed the rate increases that began in June, and because the outlook for inflation remains relatively benign, Hormats says. "The bond markets have not shown a concern about inflation," as reflected in long-term rates, such as 10-year Treasury bonds. In fact, long-term bond rates, which rose earlier in the year, had fallen back to around the 4.2 percent level by early September.

The Fed's plan to make measured increases in interest rates follows a long period of declining rates. At the beginning of the recession in 2000, the federal funds rate stood at 6.5 percent--its peak from the previous trough of 4.7 percent in November 1998. During 2001, the Fed dropped the target for the federal funds 11 times, bringing it to 1.75 percent at year's end. The FOMC acted only once in 2002, in November, to drop the rate to 1.25 percent, and once in 2003, in June, to drop it to 1.00 percent.

In June 2004 the FOMC announced its first rate boost in four years, a one-quarter-point increase to 1.25 percent. Again, at its Aug. 10 meeting, the FOMC raised its target another quarter-point to 1.50 percent.

The target was raised in spite of concern by some economists and policy-makers about a slowdown in the recovery evidenced by slower job growth in June and July. During Greenspan's July 20 testimony, however, he indicated that the recovery was not in serious trouble and that he expected it to regain its strength in the coming months. (Indeed, in his Sept. 8 testimony, Greenspan told Congress, "The most recent data suggest that, on the whole, the expansion has regained some traction" after its soft patch.)

On Sept. 21, the FOMC raised the target for the federal funds rate another quarter-point to 1.75 percent. Observers are divided on whether the rate would be raised at the FOMC's Nov. 10 meeting. Some argue that a decline in the 10-year bond rate means inflationary expectations are reduced and, therefore, there is no need to raise rates further. Yet, it is also widely believed that a federal funds rate at 1.75 percent essentially means that the Fed still has its foot on the economy's accelerator. It still needs to be shifted into neutral.

Even after three rate increases, the federal funds rate of 1.75 percent is still a long way from the 4 percent level that many market observers believe would be a "neutral" rate. A neutral fed funds rate is one that is neither accommodating growth nor restraining the economy.

"They're still in the march to get themselves back to neutral," explains David Seiders, chief economist at the National Association of Home Builders (NAHB), Washington, D.C.

Economists in the housing and mortgage sector expect the Fed, if it follows its measured approach, will push the federal funds target rate to 2 percent to 2 1/4 percent by the end of the year and to 4 percent by the end of 2005.

So what's neutral?

Yet, neutrality is not an explicitly defined target. Greenspan was typically noncommittal in his July testimony when pressed for clarification on that point. "What number is neutrality?" Sen. Shelby asked. Replied Greenspan, "Actually, we don't know what neutrality is until we get there."

Greenspan continued, "And the reason I say that is the notion of stability, or a state where the financial markets are in some form of equilibrium, depends on a number of things. You can tell whether you're below or above, but until you're there, you're not quite sure you are there. And we know at this stage that at 1.25 percent federal funds rate, that we are below neutral. When we arrive at neutral, we will know it, and we could take whatever actions we consider desirable or not desirable at that time."

There is considerable support among Fed watchers for the Fed's decision to slowly move policy back to neutral.

"I agreed with the gradualist policy of the Fed, although they have been slow to implement it," says Allan H. Meltzer, a professor of political economy at Carnegie Mellon University, Pittsburgh, and a prominent Fed watcher. Meltzer suggests the Fed mistakenly spent too much time last year worrying about deflation and less worrying about the extended stimulus the Fed's policy was giving the economy.

Measures of core inflation are rising

The Fed at this point is not motivated solely by a desire to ease up on the accelerator. It also wants to be prepared to hit the brakes in the face of inflation. Since early this year, the Fed has had reason to refocus on the inflationary potential, as energy prices soared and measures of underlying inflation in the economy also began to rise.

Since energy prices started rising, the FOMC has been watching to see what effect they are having on nonenergy prices. To separate out the direct and indirect costs of energy, the Fed watches the core inflation rate for consumers, which excludes energy and food prices.

There are two major government indexes that capture consumer prices. One is the consumer price index (CPI), which also has a core CPI measure that excludes food and energy. The other is the price index for personal consumption expenditures (PCE), which also has a core PCE index without food and energy. Both measures have been showing rising core inflation.

Although the Fed has never explicitly stated so, its reports and testimony, including statements by Greenspan, hint that the Fed favors the PCE price index over the core PCE measure.

The PCE index rose at an annual rate of 3 1/2 percent between the fourth quarter of 2003 and May 2004. Greenspan noted this in his July testimony. However, the core PCE price index, excluding food and energy, rose at a lower 2 1/2 percent during the same period. That compares with the very low price changes in 2003: 1 1/2 percent average over the four quarters of 2003 for the overall PCE, compared with 1 1/4 percent for the core PCE.

Acceleration of core prices driven by higher profits

In its semi-annual monetary policy report to Congress on July 20, the Fed concludes that core inflation has been elevated not only by the indirect effects of higher energy prices on business costs, but also by several others factors. Those factors include: increases in non-oil import prices that reflect past dollar depreciation and the surge in global prices for primary commodities. Yet, what caught Greenspan's eye was the fact that "the acceleration of core prices has been augmented by a marked rise in profit margins, even excluding domestic energy corporations," he told Congress in July.

Greenspan contends that an increase in demand from a strengthening economy has been partly responsible for the surge in nonfinancial corporate profits to 12 percent of this sector's output in the first quarter of 2004. This represents a hefty gain of 5 percentage points over the level two and a half years earlier in the third quarter of 2001. Much of this gain in profits took place during a time when business costs were subdued, Greenspan told Congress--between the first quarter of 2003 and the same period of 2004.

There was a 6 percent improvement in output per hour during this time. As the recovery proceeded and more plants use more of their capacity, it leads to lower non-labor fixed costs per unit of output. By Greenspan's accounting, then, "All of the 1.1 percent increase in the prices of final goods and services in the nonfinancial corporate sector can be attributed to a rise in profit margins rather than cost pressure" for the 12 months ending March 2004.

Greenspan, however, does not expect the trends in corporate profit building to "prompt a sustained pickup in the rate of inflation going forward." Profit margins will not rise indefinitely, Greenspan told Congress, because as profits rise, new competitors will enter the market willing to undercut prices. In addition, employment costs will rise as more firms expand employment and output to exploit the opportunity for higher profits.

Because profits of nonfinancial corporations have averaged about 10 1/2 percent of output over the last three decades, the 12 percent profit level of the first quarter is likely to moderate over the coming year, Greenspan suggested in his testimony. Indeed, he added, some of the squeeze may already be occurring with higher unit labor costs that are reflected in slowing productivity gains in the second quarter.

Greenspan's conclusion: "[T]he modest upward path of unit labor costs does not appear to threaten longer-term price stability, especially if current exceptionally high profit margins begin to come under more intense competitive pressures at home and from abroad." The fact the economy is not yet operating at full capacity should dampen cost pressures, he added.

After making a case that inflationary pressures are fairly modest, Greenspan warned: "But we cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation." The Fed will, as always, be vigilant in monitoring costs and prices, Greenspan told Congress.

Employment costs are rising

The Fed also pays close attention to another measure--employment costs--as "a critical factor of inflation," along with related trends in productivity and payroll job growth, says Goldman Sachs' Hormats.

"They're not rattled by commodity price increases. [However], what happens to wages determines how much inflationary pressure gets into the economy," Hormats says. The job numbers also play a role, since as the economy moves closer to fuller employment, pressures will mount on wages and compensation.

A key index the Fed follows is the quarterly Employment Cost Index (ECI), a measure of hourly compensation based on a survey of private non-farm businesses by the Bureau of Labor Statistics (BLS). Greenspan told Congress in July that in spite of a fairly soft labor market, employee costs rose 4 percent in the 12 months ending in the first quarter of 2004. This followed an almost identical increase for the previous year ending the first quarter of 2003.

The increases in employee costs went mostly to pay for higher benefit costs and not to increase wages. Benefit costs rose 7 percent over the year ending in March, reflecting big increases in health insurance costs and higher contributions by employers to defined-benefit retirement plans to cover earlier market losses. Wages, by comparison, rose 2 1/2 percent for the year ending in March.

The pace of employment cost increases has generally fallen well within the gains in productivity. Output per hour rose a remarkable 5 1/2 percent over the year ending in March, according the Fed, above even the impressive average of 4 percent for the last three years. Last year's stellar gains in productivity are often cited as one reason businesses delayed hiring following a pickup in business and profits.

Productivity gains, still high at 3.7 percent in the first quarter of this year, fell to 2 1/2 percent for the second quarter of 2004, the average level for the second half of the 1990s. Productivity gains in manufacturing, however, remain very high at 6.9 percent.

Hiring has picked up, although its pace remains uneven and companies remain very cautious, Greenspan stated in his July testimony. He noted that companies continue to hire temporaries at a high rate. Payroll job growth, which surged ahead in the spring, slowed down over the summer before picking up again in August, when 144,000 payroll jobs were created, according to preliminary figures. In the year ending August 2004, the economy generated 1,686,000 jobs (seasonally adjusted), averaging 140,500 a month. In a pleasant surprise, there have been gains in manufacturing jobs, which rose 65,000 in the first half of the year.

The pace of payroll job creation for May, June, July and August was somewhat slower than in the previous eight months, reaching a total of 512,000 or 128,000 a month. That is below the 200,000 a month rate that some have suggested is required for the economy to absorb all new workers and reduce the ranks of the unemployed. Even so, the unemployment rate declined to 5.4 percent in August, markedly lower than the recent high of 6.3 percent in June 2003.

While the financial markets swooned over the summer in the face of lower jobs numbers, the Fed has continued to maintain that the recovery is strong and not weakening. An improving jobs market is one of the most convincing indicators that the economy continues to recover.

Examining the inflation evidence

Not everyone agrees that the increase in core PCE prices indicates inflation is on the rise. "There doesn't seem to be evidence of inflation at the moment," says Carnegie Mellon's Meltzer. He believes the increases in the core PCE may partly be one-time events tied to higher energy prices, and thus not a source of ongoing inflation, and partly a result of the Fed's policy of fighting deflation.

Meltzer thinks the markets are mistakenly worried about the effect of energy prices on the economy. Market players, he notes, "fail to distinguish from those parts of inflation that are coming from the demand side--and are caused by the Fed or government policies--and those parts which are caused by oil price increases that are one-time changes that don't persist," Meltzer says.

The Fed has been trying to convey this distinction for some time, Meltzer says. He notes the Fed itself made the same mistake in the 1970s when it concluded that higher prices caused by reduced supply of oil was a sign of inflation when, in fact, "It was really a one-time price-level change."

Meltzer has also kept an eye on the strong money growth in the recent past, which, absent other mitigating factors, could pose potential inflationary risk. Money supply, as measured by M2, includes deposits at banks and thrifts plus money market funds and certificates of deposit (CDs) (except for individual retirement accounts [IRAs] and retirement savings). That particular money-supply measure rose from $5.65 trillion in August 2002 to $6.29 trillion in July 2004, a 10.8 percent increase.

While most economists believe the recent oil price spike is a temporary phenomenon that will disappear once more supply is provided for the world economy, others believe higher prices are here to stay. One who holds that view is William A. Niskanen, chairman of the Cato Institute, Washington, D.C., and a former acting chairman of the White House Council of Economic Advisers under President Ronald Reagan.

Niskanen believes higher energy prices were one of the causes of the recent "June swoon," when the economy began to show signs of softness. "Higher oil prices will be with us a good long while and may be increasing," he says.

Niskanen contends that higher oil prices this year are not a result of temporary supply problems in Iraq, Russia or Venezuela, but are due to permanent long-term increases in demand for oil generated by economic growth in China and India. Niskanen, who recently returned from a trip to China, says "Some of the coastal cities in China have enormous numbers of private cars." Ownership of cars is likely to continue to rise in China, fueling more demand for oil. Niskanen says activity in the markets supports the view that higher oil demand is here to stay, noting future and spot oil prices are in the $40-per-barrel range.

What does it all mean for mortgage rates?

While the Fed targets short-term rates with its monetary policy, mid-term and long-term rates are set by the broader bond markets. The interest rates for 10-year Treasury bonds help determine the direction of 30-year fixed-rate mortgages (FRMs), while shorter-term Treasuries influence the rates on adjustable-rate mortgages (ARMs).

Many economists in the housing sector contend bond prices and rates reflect a fair degree of confidence in the Fed's relatively benign assessment of the long-term potential for inflation. "Long rates are clearly behaving well," says NAHB's Seiders.

In late summer, 10-year Treasuries fell into the 4.2 percent interest rate range, while mortgage rates fell below 6 percent. While Seiders initially forecast that rates would hit 6 1/2 percent by the end of the year, he is less certain now. "We'll have to see about that. It may not make it," he says. "So much depends on the direction of core inflation. It looked worrisome for a while, but appears to be stabilizing."

David Berson, vice president and chief economist at Fannie Mae, expects mortgage interest rates to rise to a level between 6 percent and 6 1/2 percent by the end of the year and higher in 2005, but still below 7 percent. He forecasts one-year ARMs at 4 3/4 percent by the end of this year, and 5 3/8 percent by the end of 2005.

"There are some signs of inflation beyond oil prices," Berson notes, but he points out that "Inflation is still at the lowest levels in 40 years."

The underlying rate of growth in the economy is expected to be the main driver of how fast the Fed will tighten. If growth slows down, "the Fed could put off tightening," says Berson. For now, economists in the housing sector agree the economy is strong and that growth will not falter--and thus the planned measured increases in the federal funds rate will proceed at a steady pace. Furthermore, continued high productivity rates suggest growth can proceed above long-term trends without inflation.

"We could grow at 3 3/4 percent a year without inflation for quite some time," says Douglas Duncan, senior vice president and chief economist at the Mortgage Bankers Association (MBA).

Duncan says that his own forecasts for growth may be slightly higher than some others because he believes the American economy has been experiencing since 1995, a "once-in-a-generation ... shift in the structure of production within the economy" that has led to higher productivity. He expects above-average productivity gains to continue for another 10 years.

The Fed, too, in a number of studies, has noted the U.S. economy is experiencing an extended period of high productivity gains that should continue for some time--a view Greenspan has supported in testimony.

The volatility in the bond markets is also, to some extent, a referendum by the markets on the Fed's monetary policy, according to Duncan. "What the bond market is trying to decide," Duncan explains, "is [whether] the Fed knows how to conduct monetary policy in such a way as to hold the rate of inflation between 1 [percent] to 2 percent forever. Or are we starting a process by which we are going to inflate the economy again?"

Uncertainty about the Fed is "one reason there is a strong reaction from the bond market, one direction or another, every time an announcement comes out of Washington about the economy," Duncan says. "If you get 300,000 jobs created, the 10-year Treasury is going to go up. If you get 30,000, it's going to go down," he says.

The Fed has hinted in indirect and subtle ways, but has not stated explicitly, that its monetary policy is aimed at keeping inflation in the 1 percent to 2 percent range, Duncan contends. The reason this range was selected and not a lower zero percent target, he says, is that the tools for measuring inflation are crude enough that if the Fed set its target at zero percent, it might lead to deflation.

"Our institutions and markets have almost no experience in managing in a deflationary environment, whereas they do have experience managing in an inflationary environment. So the risks of very modest inflation are lower than the risks for a modest deflation. So that's why they're targeting the 1 percent to 2 percent range," Duncan says.

The outcome of the Fed's efforts to keep annual inflation in the 1 percent to 2 percent range will affect mortgage rates and housing prices. "If the Fed is successful, it will mean that the fundamentals of supply and demand will drive changes in house prices over time, as opposed to inflationary or disinflationary expectations," Duncan says.

In the past, Fed policy has had varying effects on the housing market. Duncan points out that in the 25 years prior to 1979--when inflation was on the rise--housing operated in an increasingly inflationary environment in which interest rates continually had a rising risk premium. Higher interest rates, in turn, had an affect on housing prices. In the 25 years since 1979, the risk premium for inflation has gradually been removed from interest rates, which in turn affects housing prices, Duncan says.

Statements of confidence in the strength of the economy from Greenspan and the Fed over recent months have been well-received in the markets. "The Fed has a tremendous amount of credibility," Duncan says. That credibility, he adds, is based on a fairly successful track record over the last 20 years, in spite of a few mistakes along the way--such as its failure to signal its plans to raise rates beginning in February 1994.

The market's reaction to Fed policy a decade ago "affected the housing market in a way they didn't like. So they're trying to prevent that [happening] this time by being as explicit as they can about their intentions," Duncan says.

Duncan does not expect mortgage rates to exceed 7 1/2 percent in the next three to four years. "If we get to 7 1/2 percent, that will slow home sales, but from record paces. It will get us back to the level of 2001 or 2002, or about 6 1/2 million units--still a very big number," Duncan says.

Outlook for mortgage originations

What does the current rate outlook mean for the mortgage origination market? Forecasts for originations by industry economists vary widely, depending on how they assess the impact of higher interest rates on both the economy as well as the refi market.

"The housing market can do well even with higher rates," says Fannie Mae's Berson. If the economy is picking up steam and the job market is getting better, it can offset the effects of higher rates. It might even offset all of the effect of higher rates.

Berson is forecasting $2.5 trillion in total originations for 2004 ($1.2 trillion in purchase mortgages and $1.3 trillion in refinancings). That is down from the record-breaking pace of 2003, when there was $3.8 trillion in originations ($1.2 trillion in purchase, $2.6 trillion in refi). For 2005, Berson is forecasting a $1.8 trillion year ($1.3 trillion in purchase and $500 billion in refi).

Freddie Mac is forecasting a slightly higher volume for 2004--$2.57 trillion ($1.46 trillion in purchase mortgages and $1.11 trillion in refinancings). For 2005, Freddie Mac forecasts $2.26 trillion in total originations ($1.52 trillion in purchase, $740 billion in refis).

Freddie Mac is forecasting that 30-year fixed mortgage interest rates will rise to 5.9 percent by the end of 2004, and only slightly higher to 6.1 percent in 2005. The agency is also predicting strong economic growth for all of 2004 at 3.7 percent and slightly higher at 3.9 percent in 2005. Rising interest rates "will lead to a gradual slowing of the housing market," suggests Amy Crews Cutts, deputy chief economist at Freddie Mac.

Rising interest rates will also present "a challenging environment for mortgage banking companies," says Berson. Several mortgage companies have already had significant layoffs and there will be more next year, he says.

MBA is forecasting this year will close with $2.7 trillion in originations, with more than $1.5 trillion of that from home purchase and more than $1.1 trillion for refinancings. Dun can, however, sees "a pretty big drop-off" next year as interest rates rise to 7 1/2 percent by year's end.

For 2005, he forecasts more than $1.8 trillion in originations, of which $1.4 trillion will be in purchases and $450 billion in refinancings. The industry could do better, however, if mortgage rates do not reach 7 1/2 percent, he adds.

For next year, refi business will be a higher portion of overall originations--between 20 percent and 22 percent--than it has been in the past in non refi boom years, when it has been typically in the 12 percent to 15 percent range. This higher refi component will continue, Duncan says, "because there are now so many different products, and people have learned to alter mortgage products to their current needs."

Finally, there is the uncertainty of events in trouble spots around the world--the Middle East. Venezuela, Nigeria and Russia--and how that could affect energy prices. "Do the uncertainties get worse and drive prices up?" asks Seiders, who believes as much as $10 a barrel is priced into oil as a result of uncertainty. "Everyone says it's going down. What the hell do we know about that?"

Seiders thinks if the oil situation were to get worse. "The Fed would presumably not go ahead" with its series of rate hikes. "That's the value of a flexible central bank," he adds. If the Fed goes ahead, he believes that it could drive mortgage rates to 7 1/4 percent.

Uncertainty, then, is the name of the game. Uncertainty about the oil markets. Uncertainty about potential terrorist acts. Uncertainty about whether the Fed will go forward with its measured increases in interest rates. Uncertainty about whether the strength of the economy will grow at a pace above long-term trends. And, finally, uncertainty about the magnitude of the hit the industry will take next year if and when rates move higher. In short, the mortgage business looks to remain as dynamic and unpredictable as ever.

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at

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