Too Hot, Too Cold or Just “Tight”

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It is of little surprise to housing market prognosticators and participants alike that the biggest housing trend in 2022 was the market’s response to the record-breaking increase in mortgage rates, as the Federal Reserve tightened monetary policy to tame inflation. It’s also no surprise that the questions on everyone’s mind as we enter 2023 are: what will happen to inflation and how that will influence monetary policy and mortgage rates over the course of the year.  

Headline Inflation is Over-Served

It has become apparent in 2022, and was recently confirmed in remarks by Fed Chairman Powell, that the Fed is focused on the dynamics of inflation in parts. The first part is core goods inflation, which increased dramatically in 2021 due to COVID-related supply disruptions in combination with a COVID-related demand surge for goods by domestic consumers. As the figure shows, that inflation surge is fading fast. Apparently, the transitory inflation story that was prevalent a year ago does apply, but only to the core goods sector of the economy.

The other, and significantly larger, sector of the economy is core services, which comprises over 130 million workers, 86 percent of total non-farm employment. Core services is almost 60 percent of the total Consumer Price Index and shelter makes up 57 percent of core services.

As the figure shows, service sector inflation is still rising, largely due to the shelter component. That may seem initially disheartening for the 2023 outlook. However, shelter inflation lags observed rental and house price increases by approximately one year by virtue of how it is measured. We already know that rents and prices are declining, so it’s just a matter of time — likely in 2023 — until the shelter component of inflation will cool. 

If core goods inflation is already cooling and shelter inflation is expected to do the same, then what’s left? Core services, excluding shelter. Here, the crystal ball gets cloudier. Services providers are still struggling to find labor, their primary input. As a result, service sector wages are still growing quickly — faster than the overall rate of wage growth, which is pretty strong itself. 

Less consumption demand would help, and this is why the Fed wants to keep raising rates. But by how much? The currently forecasted “terminal rate” – the Fed’s best guess at the level where they can stop raising the fed funds rate – is not too hot, not too cold, but just “tight,” which will likely be 5 to 5.25 percent by mid-next year.

Assuming the terminal rate is just right, and that core services excluding shelter inflation also shows signs of cooling in mid-2023, then we can forecast more upward pressure on mortgage rates in the first half of the year. The popular 30-year, fixed mortgage rate is loosely benchmarked to the 10-year Treasury bond. As the Fed continues to tighten monetary policy, that means more upward pressure on Treasury bonds and, therefore, mortgage rates — not the amount of pressure on mortgage rates that occurred in 2022, but just a little bit more. 

Slighty higher rates imply sales trending further lower in the first half of the year because higher rates have a dual impact on sales: pricing out buyers who lose purchasing power and keeping some potential sellers rate-locked in. Prices will also continue to correct and reflect the new dynamic of less demand relative to slightly more, yet still well below historically normal, levels of supply.

The Light at the End of the Tunnel

But there’s a light at the end of the tunnel. If inflation responds as expected in early 2023 and the Fed’s terminal rate guess is right, that will indicate that we may have a handle on inflation by mid-year. It’s even possible that mortgage rates could then actually decline modestly in the latter half of the year, as inflation expectations ease and the risk premium due to uncertainty declines. House-buying power could be given a boost from lower house prices and modestly lower mortgage rates.

There’s plenty of good reasons to believe that this could come to pass in 2023. Core goods inflation is already cooling, shelter inflation is expected to do the same in the coming months and, in theory, tighter monetary policy should cool services demand. Forecasting is challenging and economists have been notoriously bad at it. Nonetheless, this is one plausible scenario for 2023.

But I must warn the reader, I have been advised by mentors that when forecasting I should either say when, or by how much but never both. And no matter what, do not look surprised when I get it right.

This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.

To contact the author of this story:
Mark Fleming at @mflemingecon (Twitter)

To contact the editor responsible for this story:
Sarah Wheeler at [email protected]