Mortgage Rate Outlook for 2017

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Forecasting mortgage interest rates for 2017 is like trying to predict the outcome of a contest between an irresistible force and an immovable object. In this case, the irresistible force is the global economy, and the immovable object is the Fed, but in the current environment the Fed has an 800-pound gorilla that they can unleash if they choose.

Interest rates are low relative to our current position in the business cycle, but the fitful character of the recovery has made the Fed reluctant to increase them. They expected three hikes last year but ended up with one in December. Most forecasters expect this dynamic to continue through 2017, with a weak economy hampering the Fed from implementing desired rate hikes, and so predict only a small increase in rates before the end of the year.

This outlook factors in the impact of Brexit and President Trump’s disregard for free trade policies, which both bode ill for global growth in 2017. It also includes the fact that the current recovery has not fueled strong wage growth or led to an increase in first-time home buyers.

More first-time home buyers coming into the market would push rates upward, but this seems unlikely in 2017. Although recent unemployment numbers are encouraging, the labor participation rate remains low, suggesting that new jobs created by the recovery would lure workers from the sidelines before positively impacting wages. Many first-time buyers would also enter the market through a sub-prime mortgage, but that sector continues to suffer from the hangover of the pre-2008 party.

There seems little on the opposite side of the equation to argue that an increase in rates is likely, other than the Fed’s announced preference for higher rates, presumably to have the ability to lower them in the next economic downturn. This assessment ignores the potential impact of both inflation and economic growth.

Inflation was named the Fed’s arch-enemy by Paul Volker and it has never left that position, even though it has only been a theoretical threat throughout the current expansion. However, President Trump’s robust spending plan to rebuild American infrastructure could put enough money into the economy to stimulate inflation. Fed announcements have certainly documented a watchful eye on inflation, and an increase would likely cause the Fed to increase rates quickly, even at the risk of harming a fragile economy.

Of course, President Trump has promised that the economy will no longer be fragile. He and Speaker of the House Paul Ryan are such strong proponents of Regan-era economic policies it is possible they have matching tattoos of the Laffer Curve. A significant reduction in income tax rates could produce robust economic growth. A similar curve theoretically exists in regards to federal regulations, so that a simplification of the tax code in the context of lower rates could have a more pronounced effect. President Trump has already made headway in keeping a campaign promise to reduce federal regulations, and a change in the health care environment may accelerate these results.

If these policies have their intended impact, even without a dilatory awakening of inflation, the Fed would have greater latitude to raise rates. They could do so, without the perceived negative impact of announcing a change by unleashing their 800-pound gorilla, namely the bloated balance sheet inherited from the financial crisis.

This balance sheet includes $1.8 trillion in mortgage-backed securities. The Fed has trimmed its holdings through natural attrition as the underlying mortgages were refinanced due to its own low-interest rate policies. This has created a temporary floor on mortgage rates. However, if the Fed began to sell these instruments prior to maturity it would cause rates to rise.

This would meet the Fed’s policy goals of higher rates, and would fit within a narrative of reducing the size of the Federal government and undoing the legacy of the previous administration. Any need to lower rates in the future could then be met through another episode of quantitative easing rather than rate announcements.

These factors argue in favor of higher mortgage rates in 2017, particularly in the latter part of the year when fiscal and regulatory reform have begun to impact the economy. Forecasts of rates for 30-year fixed mortgages at 4.6 percent may be as much as 75 basis points too low if the Trump Administration implements policies that are successful in stimulating economic growth.