As frequent readers know, the remaining effects of inflation are isolated sectors like auto
insurance and the lagging shelter component. The U.S. labor market has normalized, with strong
employment and reduced competition among employers. Finally, economic growth remains more
resilient than many had expected. Given these conditions, the Fed seems ready to cut policy rates,
leading us to topic of the month: mortgage rates.

In our January newsletter, we debunked the oft-reported premise that the Fed sets mortgage
rates. In reality, mortgage rates and the Fed respond to other variables: namely future economic
growth and inflation expectations, with market rates typically moving first. Despite this, the
misconception persists.

Where might mortgage rates be headed, given current conditions? Conceptually, mortgage rates
are comprised of: 1) inflation-adjusted real rates; 2) long-term inflation expectations; and 3)
mortgage-related risks. Real rates reflect economic growth, which has averaged 2% over recent
decades. Long-term inflation expectations are now 2% to 2.25%, in-line with past decades.
Combined, those two components add up to 4% to 4.25%, aligning well with the 10-year Treasury
yields (currently 4.05%).

However, the third component, the premium lenders demand for mortgage-related risks, is near
2.5%, or roughly 0.75% above its historic average. Therefore, it would be reasonable to assume
mortgage rates could fall from here, if we assume the outlook for real growth and inflation is stable.
But falling rates would be largely coincidental to the Fed’s policy rate cuts.

Please understand that this is a conceptual explanation of the factors that impact mortgage rates
and provided as an education to help dispel misconceptions often reported in the media.

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