Although economists expected rates to rise this year, nobody anticipated how fast they would rise. So what went wrong? Matthew Gardener, chief economist for Windermere Real Estate, lays out what happened and what’s next.

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Please note: This article was written prior to today’s Federal Reserve interest rate hike of 0.75 percent.

You know, one of the many things I love about being an economist is that it is a remarkably humbling profession.

Just when we start to believe that our models are close to perfection, something comes along to remind us that forecasting isn’t an exact science.

If you’re wondering what I am talking about, I recently took a look at the 2022 mortgage rate forecast I put out at the start of the year and — well let’s say that rates rose at a far faster pace than I had anticipated.

Anyway, I thought that now would be a good time to take another look at rates and share my thoughts on the direction that they will likely take during the rest of the year and my reasoning behind it — and that means we need to talk about inflation.

So, a quick look back.

As you can see, there wasn’t much to celebrate in 2018, with rates rising from 3.95 percent to 4.94 percent before pulling back and ending the year at around 4.5 percent.

In 2019, rates fell following the Feds’ announcement that they were likely done with raising the Fed Funds Rate, and the mortgage market also reacted positively to the announcement from the White House that they were going to impose tariffs on select Chinese imported goods. We saw an uptick in late summer, but that was mainly due to news related to BREXIT.

In 2020, rates were dropping but spiked very briefly when COVID shut the country down and bond markets panicked. But with the Fed jumping in with an emergency rate cut and announcing that they would start buying a significant number of treasuries and mortgage-backed securities, rates tumbled to an all-time low of just 2.66 percent.

In 2021, rates rose as new COVID infections plummeted, but then dropped again as the Delta variant took hold, but ultimately trended modestly higher in the second half of the year.

And then we get to 2022. Rates started the year at just over 3.1 percent but have since skyrocketed to over 5.8 percent before a small pullback that started a few weeks ago.

In as much as economists expected rates to rise this year, nobody anticipated how fast they would rise. So what went wrong? 

Well, there’s actually a rather simple answer.

Even though we expected rates to trend higher in 2022, there were two things we hadn’t built into our forecast models:

  1. Russia’s invasion of Ukraine
  2. That inflation was going to continue climbing for far longer than we expected.

So how do things look for the rest of the year?

To explain my thinking, it’s important to remember that the bond market and, by implication, mortgage rates, hate nothing more than high inflation because when inflation is running hot, it limits demand for bonds which, in turn, forces the interest rate payable on bonds to rise and this pushes mortgage rates higher.

But what’s been fascinating to watch is that over the past couple of weeks, rates have actually been dropping which is certainly counterintuitive given where inflation is today.

And the only reason I can see for this is that bond traders were thinking that inflation might be topping out.

But then we got the June CPI numbers, and it certainly didn’t suggest that inflation was slowing; in fact, it showed the opposite.

However, even though the total inflation rate hasn’t yet peaked, I believe that a shift has actually started and that we are closer to a peak in inflation than you may think.

The June CPI report showed the headline inflation rate still trending higher, but look at the core rate — which excludes the volatile food and energy sectors — and that has actually been pulling back for the past three months.

And consumer spending — when adjusted for inflation — fell 0.4 percent in May, and that’s the first monthly drop since last December, and I expect the June number — when it comes out at the end of the month — to show spending dropping even further.

This is a very important dataset that often gets overlooked but it is starting to tell me that the economy is slowing because of inflation and slower spending acts as a headwind to further price increases.

The core PCE price index is up 4.7 percent year-over-year, but this was the smallest annual increase since last November and you can see that it is also starting to roll over. This index is actually the Fed’s favored measure of inflation as it’s more comprehensive than the CPI number as it measures the change in spending for all consumers, not just urban households. 

And the five-year “inflation breakeven” has plunged more than a full percentage point since peaking at just under 3.6 percent in late March. And this number is important as it lets us know where bond traders expect the average inflation rate to be over the next 5 years.

The Producer Price Index measures inflation at the wholesale, not retail, level and the total and core numbers are well off their peaks.

Now let’s look at some commodity prices and see what’s going on there.

The price for natural gas is down over 34 percent from its recent high, which is actually a little surprising given the war in Ukraine but these are the numbers:

  • Copper prices are down 26 percent from the recent June peak and down substantially from March
  • Soybean prices are down 10 percent
  • Wheat prices — again despite the war in Ukraine — are down 27 percent from June.

It appears as if gas prices have also rolled over. Of course, here on the West Coast it’s more expensive than the nation even when you take California out of the equation.

And finally, to cap things off, traders must also be pondering the same numbers as I am because bond yields themselves have been tumbling at both the long and short ends of the yield curve with the 10-year note still yielding less than 3 percent even after the CPI report and two-year yields — while still elevated — are still down from 3.42 percent just two weeks.

So given all the charts we have looked at, I hope that you too are seeing some light at the end of the tunnel when it comes to the likelihood that inflation is about to start easing.

No doubt, the headline inflation number for July wasn’t one that anyone wanted to see but, if the trends we have looked at continue, I still expect inflation to start slowly creeping lower, which will push bond prices higher, yields will start to — if not drop — then certainly pause — and that will allow mortgage rates to hold at, or close to their current levels for the time being.

We could see rates actually coming down, although rates will still start with a “5” for the foreseeable future.

Matthew Gardner is the chief economist for Windermere Real Estate, the second largest regional real estate company in the nation.

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