Lower Mortgage Rates in 1998
by Calvin M. Watts and Joyce McKenzie-Moser
January 1998
With Treasury yields piercing their 28-year lows and mortgage rates approaching the levels seen during the 1992-1993 refi boom, borrowers are asking the same question: Have rates hit bottom, offering a small window of opportunity to refinance, or will rates trend even lower in the coming year? We believe there are several factors that indicate interest rates will move lower in 1998--maybe a lot lower.
This time last year, there was much talk of the need to slow what was frequently described as an overheating economy. The Fed finally took action in March, 1997 and raised the federal funds rate by 1/4 percentage point, which raised interest rates across-the-board. Each subsequent policy meeting was preceded by market speculation of another rate increase. However, economic indicators were mixed--strong economic growth, unemployment at the lowest level in a quarter century, consumer sentiment at an all-time high, and all of this with little to no inflation--allowing the Fed to defer what seemed mid-1997 to be inevitable, another rate hike. Throughout the first half of 1997, anticipation of a rate hike drove nominal interest rates higher.
The picture began to change in the fourth quarter of last year, reducing the need for Fed intervention and setting the stage for lower interest rates in 1998. Asia’s financial markets began to crumble late October. U.S. companies, impacted by the Asian crisis, downward adjusted fourth-quarter and 1998 earnings estimates. Domestic stocks plunged as foreign markets nearly crashed. This prompted investors to a flight-to-quality pushing fourth-quarter bond prices to 1997 highs. Yields, which move in the opposite direction, dropped below 6.0%, having been above 7.0% earlier in the year. Concomitantly, mortgage interest rates fell below 7.0% at year-end.
The outlook for 1998 is positive in that interest rates should continue to decline. The continued financial problems abroad are expected to help slow the U.S. economy by as much as .5% this year as demand for American goods shrinks in those countries. Additionally, the devaluation of Asian currencies will help keep a lid on inflation as the prices on many Asian imports drop and become cheaper than equivalent domestically-built goods.
Tightening talk has turned to easing. Some Fedwatchers believe the economy could slow to a level that would require the Fed to lower interest rates in order to ward off potential deflation and keep economic growth alive. Deflation, a word not heard since the Great Depression, was the subject of a recent talk given by Fed Chairman Alan Greenspan to a group of economists. Although his discussion of the perils of deflation was purely academic, it gave the deflationist group ammunition for their Fed-easing theory. Fed Governor Larry Meyer offered more support for that position in a speech shortly following Greenspan's talk. He suggested the Fed would ease if the impact from the Asia’s problems becomes more severe than is currently anticipated.
Finally, the argument for lower interest rates in 1998 is supported by a current real rate of interest that is too high. Confused? Nominal interest rates (the published rates to borrow money) reflect three components: the real rate of interest plus an inflation factor (current and future) plus a premium for the risk of default. The Federal funds rate (overnight borrow rate for commercial banks) represents the first two components, as there is practically zero risk of default. It currently is 5.5%. Net of the current inflation rate (1.8%), the real rate of interest stands at 3.7%. Except during the early 1980's, the current real rate of interest has almost never been higher. If the Fed were to react to this current high rate and take steps to reduce the real interest rate to a more historical level, inflation were to continue at its current low rate (as it should based on current world economic conditions), then nominal rates would move even lower.
The inflation factor is generally consistent with all debt instruments. During high inflationary periods, nominal interest rates are driven higher. We saw this in the early 1980's when inflation was double digit, pushing mortgage rates above 15%. Currently, inflation is running at less than 2% per year. In fact, that is probably more than double the true rate of inflation. Researchers at the Federal Reserve and other experts have estimated the consumer price index (CPI) to be overstating annual cost of living increases by about one percentage point. Price measurement techniques fail to accurately capture the value of quality improvements as well as failing to measure the impact of products and services that were not available when the CPI was last formulated. If the Fed were able to devise methods to more accurately measure the CPI, the downward correction would create further pressure to lower rates.
Does all this mean lower mortgage rates are possible in 1998? Yes, they are. Nominal interest rates move in anticipation of Federal Reserve action, current and anticipated inflation, and in response to global economic conditions. If inflation stays at the current levels and the Fed drops short-term rates to help lower the real rate of interest, mortgage rates will drop further. Some economists think rates may move as much as one-half to one percentage point below current levels. The impact on mortgage rates would be dramatic with the 30-year fixed rate mortgage dropping below 6.0%. On a typical $150,000 mortgage, a drop of 1% in the mortgage rate equates to a monthly savings close to $100. This year could be the year homeowners are able to obtain a large increase in net disposable income by simply refinancing their existing mortgage.
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