Fed rate cuts will put money in pockets, but a mood shift may take time

 Even before the Federal Reserve approved its outsized half-percentage-point interest rate cut last week, financial markets had begun making credit cheaper for households and businesses as they bid down mortgage rates, cut corporate bond yields, and chipped away at what consumers pay for personal, auto and other loans.

How fast that process will continue now that the U.S. central bank's first rate cut is in the books is unclear, in particular, whether easing credit conditions will become tangible to consumers in ways that shift attitudes about the economy before the Nov. 5 U.S. presidential election.

Recent surveys suggest that while the pace of price increases has declined dramatically, the public's mood is still marred by nearly two years of high inflation - even if falling rates signal that the chapter of recent economic history is closed and will begin making it cheaper for people to borrow money.

"My daughter has been trying to buy a home for years and cannot," said Julie Miller, who works at her son's electrical company in Reno, Nevada, a state where home prices rose fast during the COVID-19 pandemic. One of seven key battleground states in the presidential race, Nevada is being aggressively contested by Vice President Kamala Harris, who replaced President Joe Biden as the Democratic candidate, and former President Donald Trump, the Republican challenger.

If housing costs are vexing Miller's daughter, higher prices at Taco Bell have caused Miller to cut back on the usual Friday night trips to the fast food retailer with her granddaughter, and left her inclined to vote for Trump because "I don't think Biden has done a great job with inflation."

Harris supporters had similar concerns about high prices even as they vouched for her as the best candidate to address the problem.

Line chart showing the Federal Reserve's key interest rate and 30-year home mortgage rates.

BORROWING COSTS DECLINE

The Fed's rate cut on Sept. 18 is likely to be followed by more, with at least another quarter-percentage-point reduction expected when policymakers begin their next two-day policy meeting a day after the U.S. election.

Just as rate increases feed through to a higher cost of credit for families and businesses, discouraging them from borrowing, spending, and investing to cool inflation, reductions in borrowing costs change the calculus for would-be homebuyers and firms, particularly small businesses wanting to finance new equipment or expand production.

Looser monetary policy, which the Fed had been signaling was on the way, has already put money back into people's pockets. The average rate on a 30-year fixed-rate home mortgage, the most popular home loan, for example, is approaching 6% after nearing 8% just a year ago. Redfin, a real estate firm, recently estimated that the median payment on homes sold or listed in the four weeks through Sept. 15 was $300 less than the all-time high hit in April and nearly 3% lower than a year ago.

But with that adjustment already done, "mortgage rates are likely to remain relatively stable for the next couple of weeks," Chen Zhao, an economist at Redfin, wrote in a post on the company's website.

Indeed, under baseline estimates from the Fed's own staff, mortgage rates are likely to level off somewhere in the mid-5% range, meaning most of the relief there has already occurred.

Banks have begun trimming the "prime rate" they charge their most credit-worthy borrowers to match the Fed rate cut. Other forms of consumer credit - the auto and personal loans where a better deal might be available to households - have changed only marginally so far, and it may take longer for banks to give up on charging higher finance costs.

Investors and economists saw last week's rate cut as less important than the message it carried of a central bank ready to loosen credit and confident that recent high inflation won't recur.

Inflation in fact has registered one of its fastest-ever declines, with the consumer price index's annual increase falling from more than 9% in June 2022 to 2.6% on a year-over-year basis last month. The Fed's preferred personal consumption expenditures price index rose at a 2.5% rate in July, near the central bank's 2% target.

Line graph showing various measures of inflation and the Federal Reserve's policy rate of interest.

SOUR SENTIMENT

The U.S. economy has been performing reasonably well despite concerns the job market might be on the brink of weakening.

New claims for unemployment benefits remain low and unexpectedly fell in the most recent week, while the unemployment rate, at 4.2% in August, has risen from a year ago but is around the level the Fed feels is sustainable without generating excess wage and price pressures. A Philadelphia Fed index of manufacturing rose recently and retail sales for August grew despite expectations for a drop.

But none of that has led to a decisive shift in public sentiment.

The share of Americans who see the economy as heading in the right direction climbed to 25% in August from 17% in May 2022, according to Reuters/Ipsos polling. Yet the share that sees the economy on the wrong track has eased to 60% from 74% over the same period.

A New York Fed survey that through early this year showed people feeling better off than a year ago and expecting more improvement in the year ahead has since been moving in the other direction even as inflation slowed further and rate cuts became more likely.

Reuters Graphics

The University of Michigan's consumer sentiment index had been improving but then dropped in recent months and remains below where it was before the pandemic.

The most recent U.S. Census "pulse" polls of households showed the share who reported trouble paying household expenses in the past week has ebbed from 2022 when inflation hit its peak but has made little improvement recently.

Line chart showing the share of households having difficulty paying expenses in the U.S.

In his press conference following the rate cut last week, Fed Chair Jerome Powell said his aim was to keep the economy on track between the central bank's two goals of stable inflation and a healthy job market. To that end, credit will ease but at no guaranteed pace.

"This is the beginning of that process," Powell said. "The direction ... is toward a sense of neutral, and we'll move as fast or as slow as we think is appropriate in real-time."

The Federal Reserve gave home shoppers what they hoped for this week: a big rate cut and a signal of more cuts to come.

Even so, aspiring homebuyers and homeowners eager to refinance should temper their expectations of a big drop in mortgage rates from here.

While the Fed doesn’t set mortgage rates, its policy pivot does clear a path for mortgage rates to go lower. But in this case, the Fed’s action was widely anticipated, so rates moved lower well before the cut was even announced.

“We’ve seen the bulk of the easing that we’re going to get already this year,” said Danielle Hale, chief economist at Realtor.com. “I wouldn’t be entirely surprised if mortgage rates ticked up a bit from here before declining again.”

What’s up with mortgage rates?

When mortgage rates rise, they can add hundreds of dollars a month in costs for borrowers. The average rate on a 30-year mortgage rose from below 3% in September 2021 to a 23-year high of 7.8% last October. That coincided with the Fed jacking up its benchmark interest rate to fight inflation.

Rates have been mostly declining since July in anticipation of a Fed rate cut. The average rate on a 30-year mortgage is now 6.09%, according to mortgage buyer Freddie Mac. That’s down from 7.22% in May, its peak so far this year.

Even a modest drop in mortgage rates can translate into significant savings over the long run. For a home listed at last month’s median U.S. sales price of $416,700, a buyer in Los Angeles who makes a 20% down payment at the current average mortgage rate would save about $312 a month compared to the cost of buying the same home in May.

So, it’s time to buy?

While lower rates give home shoppers more purchasing power, a mortgage of around 6% is still not low enough for many Americans struggling to afford a home. That’s mostly because home prices have soared 49% over the past five years, roughly double the growth in wages. They remain near record highs, propped up by a shortage of homes in many markets.

Mortgage rates would have to drop back to near rock-bottom lows from three years ago, or home prices would have to fall sharply for many buyers to afford a home. Neither scenario is likely to happen any time soon.

Economists and mortgage industry executives expect mortgage rates to remain near their current levels, at least this year. Fannie Mae this week projected the rate on a 30-year mortgage will average 6.2% in the October-December quarter and decline to an average of 5.7% in the same quarter next year. It averaged 7.3% in the same period in 2023.

Mortgage rates are influenced by several factors, including how the bond market reacts to the Fed’s interest rate decisions. That can move the trajectory of the 10-year Treasury yield, which lenders use as a guide to pricing home loans.

“Ultimately, the pace of mortgage and Fed rate declines will be dictated by economic data,” said Rob Cook, vice president at Discover Home Loans. “If future data shows that the economy is slowing more than expected, it would increase pressure for the Fed to take more aggressive action with rate cuts which would likely translate into lower mortgage rates available to consumers.”

Buy now, or wait for lower rates?

Sales of previously occupied U.S. homes have been in a deep slump dating back to 2022 and fell 2.5% last month. So far, the pullback in mortgage rates has yet to spur a meaningful rebound, although sales did rise slightly in July.

The muted outlook for mortgage rates leaves prospective buyers and sellers with a familiar dilemma: Test the housing market now or hold out for potentially lower rates.

Nick Young, an attorney who moved his family this year from Phoenix to Evergreen, Colorado, has opted to rent after seeing how competitive the homebuying market was last spring.

With a homebuying budget between $1 million and $1.5 million, he and his wife are still searching for that perfect gem — a house with five bedrooms to grow in with their three kids.

They’re watching mortgage rates, but also other variables, including inflation, the health of the economy overall, and the presidential election.

“There’s not a ton of incentive to buy currently,” Young said before the Fed announcement. “But timing the market is a fool’s errand.”

Real estate agents from Phoenix to Tampa, Florida, say many home shoppers are waiting for mortgage rates to fall below 6%. Some are hoping rates can return to the lows of three years ago.

“What I try to do is bring them back to reality,” said Mike Opyd, a broker with Re/Max Premier in Chicago. “I tell them, ’ If you’re serious about buying, get in now.”

To Opyd’s point, the pullback in mortgage rates and a pickup in the supply of homes on the market make for a favorable backdrop for home shoppers this fall, typically a slower time of the year for home sales.

Waiting for rates to possibly ease further next year could leave buyers facing heightened competition for the home they want. Meanwhile, potential sellers may still stay put.

“Keep in mind that 76% of people with a mortgage have a rate below 5%,” said Leo Pareja, CEO of eXp Realty. “So, we may see the supply-demand imbalance actually get a little worse in the near term.”

Refinancing spree

First-time homebuyers Drew Yae and his wife bought a two-bedroom, 1.5-bath townhome in Bellingham, Washington, last month.

In February, Yae, a compensation analyst, was initially quoted a 7% mortgage rate. By the time the deal was done, his rate had come down only to about 6.63%.

“I would like to refinance at 5% or 5.25%, but I just don’t know if that’s realistic and if that’s going to take more than two years to get there,” he said.

Yae could lower his monthly payment by roughly $300 a month if he refinanced his $407,000 home loan to 5.5%.

One rule of thumb to consider when refinancing is whether you can reduce your current rate by half to three-quarters of a percentage point.

Demand for home loan refinancing has been growing. Last week, refinance applications surged 24%, according to the Mortgage Bankers Association.

Lenders are increasingly leaning into the old “date the rate” adage by pairing original loans with refinancing incentives from the jump. After buyers saw record high interest rates that peaked about a year ago at around 8%, many are marketing offers that essentially give buyers a way out of their current rate once it comes back down as a way to quell buyer hesitancy.

“It is getting a lot more emphasis,” said Mike Fratantoni, chief economist at the MBA. “Getting locked into a 7% rate forever — for a first-time buyer, it is terrifying.”

Navy Federal Credit Union said it started offering its popular “no-refi rate drop” in 2023, which allows buyers to lower their rate for a $250 fee while maintaining the rest of the terms on the original loan.

Many homebuyers are opting both for the temporary rate buydowns and free refinancing, said Darik Tolnay, branch manager of CrossCounty Mortgage in Lakewood, Colorado.

“They all want a home, so if someone comes up with an idea to make it more affordable, given the general sentiment, people are desperate to have options,” Tolnay said.a