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Mid-course correction.

MID-COURSE CORRECTION MBA economists have changed their forecast for the year. Mortgage rates are not expected to drift as low as forecasted earlier.

For several months the MBA economics department has been forecasting that interest rates would decline during the first half of 1990, with effective rates on fixed-rate mortgages reaching 9 1/4 to 9 1/2 percent by mid-year. In response to that decline, we had expected a modest rebound in housing starts, existing home sales, and one-to four-family mortgage originations above their rather sluggish 1989 levels.

Over the past two months, however, long-term interest rates have risen sharply, calling that forecast into question. At times like these we must return to square one and reassess the underlying fundamentals.

Let's begin with a brief review of recent history. Long-term interest rates were rising during most of 1987 and 1988 and peaked in early April of 1989, with effective FRM rates reaching 11 1/2 percent and the yield on the 30-year Treasury bond topping out at around 9 1/4 percent. Rates then drifted lower during the remainder of the year, with effective fixed-rate mortgage (FRM) rates reaching around 10 percent while the long bond hit 7.8 percent in mid-December.

What forces led to the rise in rates during 1987 and 1988 and then caused rates to decline during 1989? The answer is pretty obvious. The economy grew at a very robust pace during 1987 and 1988. As a result, the unemployment rate was declining, capacity utilization was rising, and inflation pressures were building. Concerned by this acceleration of inflation, the Federal Reserve tightened its monetary policies, and interest rates rose, particularly on short-term securities.

By early 1989 evidence began to mount that the economy's growth rate was beginning to slow, and with this slowing came a modest easing of inflation. In response, the Fed began to loosen monetary policy, and by year-end the federal funds rate was down to 8 1/4 percent. Long-term interest rates declined in response to both the Fed easing and the signs of cyclical weakness. The decline in long-term rates may have gotten a bit ahead of reality in the sense that the levels of long-term interest rates reached in December were based partly on expectations that the Fed would continue easing during the first half of 1990.

Why did this trend of declining interest rates stop in mid-December and reverse direction in January and February? In our opinion, several events are responsible. First, cold weather in December caused prices of food and energy to soar, raising concerns about inflation. Second, some economic indicators released in January and February were some what stronger than credit markets were expecting. Both of these developments led to doubts that the Federal Reserve would ease further, doubts that were verified in mid-January, when several members of the board of governors stated that they would not favor further easing. Following Chairman Greenspan's congressional testimony in mid-February, in which he suggested that the risk of recession had declined significantly, bond market investors had to abandon expectations of further Fed easing in the near future. This change in expectations caused long-term rates to rise.

The bond market has also been concerned about the strength of demand for dollar denominated assets by foreign investors and the continued lack of fiscal discipline in Washington. On the foreign front, markets in the U.S. were jolted by a sharp rise in Japanese long-term bond rates and the continuing climb of long-term interest rates in West Germany. In the latter country, long-term government bond rates are now somewhat higher than those in the U.S. The realization that long-term rates abroad might increase further has had a chilling effect on U.S. bond investors.

Potential developments on the fiscal front have been equally sobering. The Moynihan proposal to cut social security (payroll) taxes threatens an explosive increase in the federal deficit. While the proposal appears to have less than a 50/50 chance of passage, investors cannot afford to ignore it. Another worry is the possibility that, if real GNP growth were less than 1 percent again in the first quarter, the Gramm-Rudman deficit targets could be suspended.

That leads to the "$64,000" question, do we still think rates will decline in the months ahead? The answer is a timid yes, but only part of the recent run-up of rates is likely to be reversed. We now expect yields on the long bond to return to the 8 to 8 1/2 percent range during the second quarter, while effective FRM rates return to the 10 to 10 1/2 percent range. Our reasoning is that, as yet, the fundamentals that led to slower economic growth and lower interest rates during 1989 remain in place. Overall economic growth is still sluggish, and probably will remain so at least through midyear. Some further modest easing by the Fed, therefore, cannot be ruled out entirely.

Nonetheless, international developments may well be the dominant determinant of U.S. interest rates during this period. The U.S. continues to run a substantial deficit on its international trade of goods and services, which is financed by inflows of capital from abroad. Worries are likely to persist that foreigners may find U.S. interest rates unattractive - worries that contributed to the increase in long-term U.S. bond rates just before the recent Treasury refunding.

The dangers that bond market investors see are too real to be ignored. An unbelievable pace of events in Central and Eastern Europe is creating tremendous investment opportunities that may divert capital away from the U.S. Moreover, U.S. exports of capital goods and industrial supplies and materials may eventually increase as this capital formation process gets underway in Europe. Thus, while domestic growth is likely to be sluggish in the near-term, by late 1990 or 1991, we may once again experience an exportled reacceleration of growth.

This increased influence of international factors in the determination of domestic interest rates means that economic forecasters are now sailing in uncharted waters. Accordingly, fairly abrupt changes in course may be required as new information becomes available.

Richard W. Peach is staff vice president and deputy chief economist at the Mortgage Bankers Association of America.
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Title Annotation:Mortgage Bankers Association economic predictions
Author:Peach, Richard W.
Publication:Mortgage Banking
Date:Apr 1, 1990
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