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‘It’s Finally Happening’: Cooler Inflation Opens the Door to Rate Cut

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Investors rejoiced on Thursday after the Consumer Price Index revealed that inflation had cooled at a more accelerated rate than expected in June, providing a pathway for the Federal Reserve to lower interest rates. 

The news sent yields on the 10-year Treasury — typically a leading indicator for mortgage rates — tumbling as soon as the inflation data was released Tuesday.

The Consumer Price Index rose 3 percent in June on an annual basis, which was lower than investors expected, according to data released by the U.S. Bureau of Labor Statistics. Part of the cool-down came from the housing market, as a slowdown in rent growth showed up in official inflation data.

Jay Parsons | Rental housing economist

“It’s finally happening,” wrote Jay Parsons, a real estate economist who has noted for over a year that falling rents showed national inflation would plummet. 

The data showed the price of rent rose by 0.3 percent, the lowest rate of increase since August 2021, when private indices showed the price of rent was spiking.

Rent growth peaked in February 2022 and fell for 18 months before leveling out at just over 3 percent annual growth, according to the Zillow Observed Rent Index.

The price of shelter makes up about a third of the weight of inflation. When the price of rent and other goods spiked during the COVID housing boom, inflation spiked. But research has shown there’s a long lag-time for inflation data to reflect a drop in rent, so the spike in rent helped keep inflation high.

“A full year of weak (new lease) rent growth (in private sector datasets) is now translating to significant cooling in shelter inflation,” Parsons wrote.

Inflation eased in June: CPI

Core CPI, which excludes volatile food and energy prices, was up 3.3 percent in June from a year ago, an improvement from 3.4 percent annual growth in May.

The Federal Reserve’s preferred gauge of inflation, the personal consumption expenditures (PCE) price index, fell to 2.6 percent in May from a year ago, the Commerce Department’s Bureau of Economic Analysis reported June 28. The PCE index for June will be released July 26.

Wider ’30-10 spread’ keeping mortgage rates elevated

Before the pandemic, mortgage rates were running about 2 percentage points higher than the yield on the 10-year Treasury note. But the “30-10 spread” between mortgage rates and 10-year Treasury yields widened to 3 percentage points during the pandemic, magnifying the impact of rising interest rates for mortgage borrowers.

Although the 30-10 spread has gradually narrowed to 2.6 percentage points as of Monday, it remains “significantly higher now than it should be,” said Matthew Gardner, an economist with Gardner Economics in Seattle.

Matthew Gardner | Gardner Economics

“Banks have increased that spread,” Gardner said. “There’s a bigger risk premium because they believe that at some point mortgage rates will drop and people will refinance their homes, and they’ll lose revenue.”

With the 10-year Treasury yield dropping 10 basis points to 4.17 percent Thursday, rates on 30-year fixed-rate mortgages would be around 6.17 percent if the 30-10 spread was at pre-pandemic levels. A basis point is one-hundredth of a percentage point.

Instead, 30-year fixed-rate loans were averaging 6.88 percent Wednesday, according to rate lock data tracked by Optimal Blue.

If mortgage rates also come down by 10 basis points Thursday, that would put 30-year mortgage rates at around 6.78 percent. Although Optimal Blue data lags by a day, an index maintained by Mortgage News Daily showed rates on 30-year loans dropping 14 basis points Thursday.

After spiking to the highest level in over two decades last year after a series of aggressive Fed rate hikes, mortgage rates now look like they have room to come down.

“Over the past two years, the economy has made considerable progress toward the Federal Reserve’s 2 percent inflation goal, and labor market conditions have cooled while remaining strong,” Fed Chair Jerome Powell said in testimony before House and Senate lawmakers this week. “Reflecting these developments, the risks to achieving our employment and inflation goals are coming into better balance.”

But Powell said policymakers continue to make decisions “meeting by meeting,” and want to see more evidence that inflation is moving sustainably toward the Fed’s target of 2 percent before cutting rates.

Another report out Thursday from the Department of Labor showed initial jobless claims dropped last week to 222,000, down from 239,000 the week before and “well below” the 235,000 expected by economists, Pantheon Macroeconomics Senior U.S. Economist Oliver Allen said in a note to clients.

While unemployment claims had been trending up this year, Allen said seasonal quirks make it hard to say whether that trend will be reversed.

“Our big picture view remains that the uptrend in initial claims will continue, as slowing consumer demand and high interest rates prompt companies to lay off more stuff to defend margins,” Allen wrote. “This is a story supported by several leading indicators, including the WARN data on layoff announcements, and series tracking consumers’ worries about losing their jobs.”

Pantheon Macroeconomics is projecting that the Fed will cut short-term rates by 1.25 percentage points by the end of the year, starting with a 25 basis-point cut in September.

The CME FedWatch Tool, which tracks futures markets to predict future Fed moves, put the odds of a September rate cut at 94 percent after the release of the latest CPI data. That’s up from 73 percent on Wednesday and 53 percent on June 11.

Futures markets are now pricing in a 49 percent chance that the Fed will cut rates by at least 75 basis points by the end of the year, up from 27 percent Wednesday and 14 percent on June 11.

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