Main Street Macro: The next Fed rate cut might disappoint. Here’s why.

The recent slowdown in inflation has left market watchers more confident that Federal Reserve policymakers will cut interest rates at least once this year. What’s harder to predict is how those rate cuts might affect the economy.

The impact of rate changes always has been something of a wild card. That’s why economists spend a lot of time thinking about the transmission channels of monetary policy, and will focus on the topic at next month’s Jackson Hole Economic Symposium.

Housing typically has been the most direct route for delivering the benefits of monetary policy to Main Street. In theory and historically, rate cuts do two things: Lower borrowing costs and increase supply and demand.

Rates on 30-year fixed mortgages don’t move in lockstep with the Fed’s short-term benchmark rate, but mortgage costs tend to be guided lower when the Fed cuts rates. And lower borrowing costs boost supply from homebuilders, who can increase production at lower costs, and are incentivized to do so in anticipation of greater demand from buyers. As demand increases, prices rise, which incentivizes existing homeowners sell, too, further boosting supply.

It all sounds great in theory. But the housing channel for transmitting the positive economic boost of lower interest rates to Main Street has grown less effective than it once was. Here are three reasons why.

Borrowing costs are still too high

The Consumer Price Index for June delivered some relief from relentlessly high inflation in housing costs. Month over month, the cost of shelter rose 0.2 percent in June, only half the rate of increase of the previous three months.

That’s great news for inflation, but the high cost of housing already has taken a toll on affordability. With higher interest rates and rising prices, the cost of housing as a share of median household income is more than 43 percent, according to the Federal Reserve Bank of Atlanta. That’s a big jump from 2021, when the typical household spent less than 30 percent of its income on housing.

Even strong wage growth hasn’t offset higher mortgage rates and home prices. A 30-year, fixed-rate mortgage now costs more than double what it did in 2021.

The Fed would have to cut its benchmark rate significantly for mortgage rates to fall back to the rock-bottom levels that sustained the housing market after the 2008 financial collapse and through the pandemic.

Even if the cost of financing a home does fall dramatically, it will take time. Meanwhile the cost of buying continues to rise. The median sales price for existing homes jumped 5.8 percent in May from a year earlier to $419,300, its highest on record.

Homeowners are locked in

Among homeowners with fixed-rate mortgages, 63 percent are paying 4 percent or lower, according to economists at the Federal Housing Finance Administration, who write that for every percentage point that market rates exceed a homeowner’s origination rate, the chance of that homeowner selling falls by more than 18 percent.  

Because mortgage rates were so low for so long, most homeowners were able to refinance into historically low rates. That means a cut to the Fed’s benchmark rate is likely to have a more muted effect on housing inventory and sales than it has historically.

A refi wealth surge is unlikely

Low mortgage rates and strong price appreciation have caused the value of home equity to surge by 41 percent to a collective $33 trillion, according to Federal Reserve data. 

Historically, a Fed rate cut spurs people to refinance their houses at lower rates and use some of the proceeds to fund other spending, which boosts economic growth.

With the bulk of homeowners already locked into low mortgage rates, a refi boom that taps into home equity wealth is far less likely.

My take

We’ve been waiting for a final slowdown in shelter costs. This week’s Personal Consumption Expenditures price index, due Friday, likely will mirror the CPI slowdown in the growth of housing costs.

But while a slowdown in housing inflation supports the case for a Fed rate cut (or two) this year, that easing might not deliver the economic boost we’re used to seeing from the housing market.

The week ahead

Tuesday: Existing home sales from the National Association of Realtors kicks off a busy week for economic news.  With the summer homebuying season in full swing, I’ll be looking at inventory for a clue to whether the housing inflation slowdown can continue.

Wednesday: The Census Bureau releases new home sales for June. With more properties on the market, prices for new homes have fallen from last year. I’ll be watching for the trend to continue.

Thursday: The Bureau of Economic Analysis delivers its first look at second quarter GDP. Census data on durable goods orders and inventories will give us an indication of how demand is faring.

Friday: The data highlight of the week is PCE inflation from the Bureau of Economic Analysis, the Fed’s preferred measure of inflation. PCE inflation is expected to show more progress toward the central bank’s 2 percent target due in large part to an anticipated drop in rental prices. June Personal Income and Outlays data from the BEA will signal how much momentum the consumer had as we entered the third quarter.