US mortgage market mutes monetary policy mechanism

We estimate the gap between existing and market rates for US mortgages has provided consumers with an extra USD 600 billion since early 2022 (up to 2% of disposable income). This has undermined the monetary policy transmission mechanism and helps explain why US consumer spending has remained resilient to monetary tightening. Locked-in mortgage rates may similarly limit the effectiveness of monetary policy easing, adding to the list of downside risks to growth and also to affordability pressures. For example, year-on-year house price growth has moderated to below 6%, but prices remain 60% above 2020 levels.

• Fixed-rate mortgages provided US consumers with an estimated extra USD 600 billion to spend since early 2022, dulling the effectiveness of monetary policy and supporting industry premium growth during the tightening cycle.
• We expect limited stimulus from monetary policy easing due to mortgage market structure and broader interest rate insensitivity.
• With spending tailwinds fading and equity markets priced to perfection, the downside risks to growth have risen, threatening a sharper easing cycle over the next year than our baseline currently assumes.
• We see limited impacts on insurance premium growth projections this year but see higher  downside risks in 2025.

During the recent Federal Reserve monetary policy tightening cycle, market rates for US mortgages exceeded the average rate borrowers paid on existing mortgages by as much as 3.2 percentage points. Such a gap has significant economic implications: it lowers monetary policy effectiveness by supporting consumer resilience during hiking cycles and reduces the stimulus effect when rates ease. By the end of 2Q24, the market rate for mortgages was roughly 7%, compared to an average existing mortgage interest rate of about 4%. We reviewed this gap for the two years through 2Q24 and estimate that homeowners with fixed-rate mortgages amassed over USD 600 billion in "savings" from their mortgages in the post pandemic expansion (see Figure 1), amounting to nearly 2% of personal consumption spending. A dollar not spent on mortgage payments is a dollar free to spend elsewhere. This helps explain why recent policy tightening did not, initially, appear to slow the economy.

Figure 1: Existing and new mortgage interest rates and effect on personal disposable income

The structure of the US mortgage market causes this effect. Over 95% of US home loans are 15- or 30-year fixed-rate mortgages.^[1] Market rates for 30-year mortgages have exceeded 6% since September 2022,^[2] but over 85% of borrowers still pay less than 6% interest.^[3] More than half still pay less than 4% (see Figure 2), while 40% of homeowners have no mortgage at all. When weighting loans in dollar terms, the effect is even more pronounced. For example, 22% of mortgages still have interest rates below 3%, but the number increases to 27% when weighted by mortgage value.

Figure 2: US mortgage interest rate levels (weighted by no. of loans)

For insurance (and other consumer-facing industries), the mortgage lock-in effect has supported strong consumer demand over the last two years, partly offsetting the impact of higher input costs, including the effect of interest rate increases on cost of capital. However, the same mechanism will operate in the other direction, partially counteracting the effectiveness of rate cuts as the Fed eases monetary policy to stimulate consumer demand. As rate cuts take effect, most mortgage borrowers will continue to make the same mortgage interest payments, with limited motivation to refinance or prepay. This informs our view that there is limited upside to GDP growth over the next 12 months and greater downside risks to insurance premium growth in 2025, though other parts of the housing market such as residential construction will benefit as borrowing costs decline.

In addition to the economy's limited interest rate sensitivity in mortgage markets, we see mounting downside risks that will partially offset the boost from lower interest rates over the next year and raise the risk that the Fed will have to cut rates more aggressively than our baseline assumes. For instance, despite a healthy 2.6% increase in consumer spending in 2Q24, the labor market has shown broader signs of weakness in recent months. The US hiring rate has slowed to 3.7%, the lowest rate since 2014, and nominal wage growth cooled to 3.6% in July from 4.7% a year earlier. A further slowing in consumer spending could trigger a slowdown in business activity and, in turn, a sharper loosening in labor market conditions as firms continue to navigate elevated input costs, with reduced pricing power and weaker margins.

Slowing growth over the coming quarters also raises the risk of an earnings-led decline in equity prices, especially if macro data disappoints in the months ahead. This would reduce tailwinds from wealth effects and business investments that have supported growth in recent quarters, leading to a tightening of financial conditions, and threatening a sharper economic slowdown in the absence of more aggressive monetary policy support. Even as inflation slows, households will contend with affordability pressures as price levels remain elevated. For example, while year-on-year house price growth has moderated to just 5.9% through May according to the S&P/Case-Shiller Home Price Index, the median existing home price has risen 60% since early 2020. Meanwhile, credit card delinquencies have also risen above pre-pandemic levels for households across all income groups, ⁴ pointing to higher debt burdens that do not see immediate relief from lower interest rates.