Sunday, September 16, 2012

How much will lower mortgage rates help the US economy?

As mortgage rates in the US hit new lows, the US consumer should benefit. The question is how much difference does the mortgage rate make in improving economic growth. We should see the impact on the economy from two sources: higher home sales due to improved "affordability" as well as more money in consumers' pockets due to refinancings at lower rates.

30y average US mortgage rate (

1. We know that as mortgage rates declined, home affordability improved. It is important to note however that the rate is not the only component of affordability. Factors like home prices and disposable income must be included as well. Let's take a look the Housing Affordability Composite Index from the NAR. Here is how it is defined.
When the index measures 100, a family earning the median income has exactly the amount needed to purchase a median-price resale home using conventional financing. An increase in the home affordability index means that a family is more likely to be able to afford the median priced house.
As homes become more "affordable", we should see increased sales. What's particularly important is to see higher sales of new homes because that stimulates the construction sector and should create jobs. The chart below compares the affordability index, which indeed has been on the rise, with existing home sales. Except for the First-Time Homebuyer Credit spike and drop, sales have not been responsive to improvements in affordability.

Affordability Index: White; Existing Home Sales: Yellow (Bloomberg)

Now we make the same comparison with new single family home sales.

Affordability Index: White; New Home Sales: Green (Bloomberg)

New home sales have been on the rise slightly, which is gradually improving new home construction.  But so far this trend in construction has not contributed to better employment conditions. This is evidenced by poor US employment-population ratio (discussed here) below. The jobs created in construction are not enough to offset growing labor force due to increasing US population as well as jobs lost elsewhere.

New Privately Owned Housing Starts: White;
Employment-population ratio Yellow

To significantly impact hiring in the US, one needs a far larger increase in new home sales - something that may take years, in spite of improved housing affordability.

To be sure, the US housing picture is improving and home prices are on the rise. But as discussed earlier, at this stage it has less to do with "affordability" (which has been high for some time now) and more with the demographics of growing US population (discussed here).

If mortgage rates suddenly decline from 3.50 to 3.25 or 3.00 and the affordability index goes up further (although as home prices improve, affordability could stall), there is no evidence that home sales (and therefore construction) would all of a sudden begin to grow at rates beyond their existing trend. It certainly hasn't happened as rates dropped from 5% to 3.5%.

2. Now let's take a look at the impact on consumer spending from additional refinancings due to lower mortgage rates. The data here speaks for itself.

Every 25bp improvement in primary mortgage rate is worth only about $5bn in the US consumers' pockets. That's in part due to limitations of borrowers' ability to refinance because of insufficient equity in their homes or poor credit history. Let's say we improve mortgage rates by 50bp (to 3%), translating into $10bn in savings per year. Consumers in the US spend about $11 trillion annually. The savings from the reduced mortgage rates therefore constitute 0.09% in incremental consumer spending (assuming consumers spend it all). Sadly increased gasoline and food prices will more than offset this improvement.

It is quite clear that even though lower mortgage rates are helpful to economic growth, another 50bp (or even larger) reduction in rates will have only a marginal impact on hiring and growth.
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