Inflation and the Fed will push mortgage rates up

Housing economists say the growing optimism will push rates up, if slowly.

Mortgage rates plumbed new depths in December and January, setting all-time lows south of 3 percent. Rates have bounced around since then, topping 3.3 percent in March before dropping to 3 percent this summer.

Their trajectory for the rest of 2021 depends on a factor that hasn’t played a prominent role in the mortgage market for decades — inflation and the Federal Reserve’s response to rising prices.

That’s according to Greg McBride, CFA, Bankrate chief financial analyst. With coronavirus vaccines widely available, optimism about the U.S. economy abounds. Yet, so do fears about rising inflation. While the Fed insisted this summer that soaring prices were “transitory” and would fade away, that no longer seems an accurate reading.

“Inflation is running hot and even the Fed acknowledges what we all felt in the pocketbook, that it may last longer than they thought,” McBride says. “Mortgage rates could tick a bit higher in the fourth quarter if inflation remains stubbornly high and the Fed is slow to begin tapering asset purchases, despite continued economic strength.”

Housing economists say the growing optimism will push rates up, if slowly. The Mortgage Bankers Association, for instance, expects the average 30-year fixed rate to reach 3.1 percent by the end of 2021. Its forecast three months ago called for rates to hit 3.6 percent in late 2021. In other words, accurately predicting rates isn’t easy, especially in a global pandemic.

With rates trending upward, the refinancing boom of 2020 is slowing dramatically, says Michael Fratantoni, chief economist at the Mortgage Bankers Association. He expects refi volume in the fourth quarter of 2021 to plunge to barely a third of the levels seen in the fourth quarter of 2020.

While mortgage rates will rise enough to discourage refinancing, they’ll remain low enough to make homebuying attractive, Fratantoni says. He predicts record-breaking purchase mortgage volumes in 2021, and then again in 2022 and 2023.

“We’re anticipating a very strong housing market,” he says.

The Federal Reserve doesn’t control mortgage rates, but the central bank does set the overall rate environment. The Fed slashed its federal funds rate when the coronavirus recession began in early 2020, and it had signaled that it would keep rates low for years, which would translate to little upward pressure on mortgage rates. However, that calculus has changed in recent months.

“The job market has improved, inflation is running hot and supply chain constraints are persisting,” Fratantoni says. “As a result, it is not surprising that the Fed will begin to remove accommodation.”

At its Sept. 22 meeting, the Fed sped up its timetable for rate hikes. Most Fed members now expect an interest rate hike in 2022 — “which is faster than many market participants had previously anticipated,” Fratantoni says.

While the federal funds rate doesn’t directly affect mortgage rates, there is a strong correlation between the rate on 10-year Treasury bonds and the 30-year mortgage. That spread widened in the spring and summer.

The typical gap between the 10-year government bond and the 30-year fixed-rate mortgage is 1.5 percentage points to 2 percentage points. During the scary early days of the COVID-19 pandemic, that spread rose as high as 2.7 percent. However, the gap has returned to normal.

Generally, an improving economy correlates to rising mortgage rates.

Economists and investors think the U.S. economy will continue its uneven rebound. However, it’s unlikely that mortgage rates will soar, housing economists say.

Will this latest run-up in rates last? No one knows that answer for certain. But housing economists and market watchers generally agree that a variety of factors — including inflation, the economic recovery and the Fed’s pace of bond buying — are lining up to nudge rates higher.

And for the millions of homeowners who have yet to lock in historically low interest rates by refinancing, that money-saving opportunity soon might fade away.

“It’s more likely that rates will go up than down,” says Isaac Hacamo, an assistant professor of finance at Indiana University’s Kelley School of Business. “If you haven’t refinanced in the past few years, I would do it now.”

The Fed’s ‘taper’ defined

When the coronavirus pandemic cratered the U.S. economy in March 2020, the Fed responded with full force. The central bank slashed its key federal funds rate to near zero. The Fed also pumped money into the economy by snapping up mortgage-backed securities and other bonds to the tune of $120 billion a month.

To unpack that a bit, most mortgages issued in the U.S. are bundled together as mortgage-backed securities, then sold to investors. The Fed stepped in as a buyer of those securities, a way to make sure credit continues flowing at low interest rates.

The bond buying and other emergency measures came as part of an aggressive stimulus designed to keep the economy from going into the sort of deep freeze that made the Great Recession such a slog. After this recession, the first downturn in a decade, the U.S. economy quickly recovered much of its lost ground.

Labor markets rebounded. And some say the federal response worked a little too well — stocks have soared, and home prices surged to record levels. Inflation, long absent from the U.S. economy, is back. That has led calls for the Fed to stop stimulating the economy quite so much.

“The problem in the housing market is not that it needs support. It’s that it is pricing out Americans,” Mohammed El-Erian, chief economic adviser at Allianz SE, told Bloomberg TV. “Americans can no longer afford what’s happening in the housing market.”

At last month’s meeting, the Fed said all of those factors mean it’s time for the central bank to stop flooding the economy with money by snapping up bonds.

“If progress continues broadly as expected, the committee judges that a moderation in the pace of asset purchases may soon be warranted,” the Federal Open Market Committee said in its post-meeting statement.

Economists sum up that meandering mouthful of verbiage as the “taper.”

Mike Fratantoni, chief economist at the Mortgage Bankers Association, says the Fed’s September announcement has all but committed the central bank to announcing a taper at its next meeting in early November.

“To paraphrase Chekov, if at the September meeting the Fed lays out a tapering plan, they must use it in November,” Fratantoni says. “There would need to be a significant negative surprise in the incoming data for them to delay.”

However, even if the Fed follows through and slows its pace of bond buying, Fratantoni doesn’t expect a sharp rise in mortgage rates.

“The pending taper and change to the monetary policy outlook will likely contribute to a modest increase in mortgage rates over the medium term,” he says.

Lynn Reaser, chief economist at Point Loma Nazarene University, likewise predicts a steady rise in mortgage rates rather than a steep climb. Indeed, it’s possible that the most dramatic move already happened.

“The market seems to have already priced in a slowing down of Fed asset purchases,” Reaser says. “The Fed is likely to announce only a small adjustment to the amount of securities it purchases each month, from $120 billion to $110 billion or $105 billion. The market will have already anticipated the announcement — and might even welcome it as a step to stem inflation.”