The recent Consumer Price Index (CPI) reading has sent shockwaves through the financial market, causing a stir among investors and analysts alike. The 0.1 miss on the expected inflation rate has led to a significant overreaction in both the bond and stock markets, leaving many wondering about the future of interest rates and the economy as a whole.

However, amidst the chaos, there are reasons to believe that mortgage rates may still drop in the coming months, despite the CPI shock. To understand why, it's essential to take a closer look at the factors driving the CPI and the Federal Reserve's decision-making process.

The Role of Shelter Cost in the CPI

One of the most significant contributors to the CPI's recent reading is the shelter cost component, which includes rent and owner's equivalent rent. This component makes up a staggering 45% of the Core CPI, making it a heavily weighted factor in the overall inflation rate.

The problem with the shelter cost component is that it relies on a flawed system of data collection. The owner's equivalent rent, for example, is based on surveys asking homeowners what they would rent their homes for. This method often leads to inflated estimates, as homeowners tend to overvalue their properties when responding to such surveys.

The Federal Reserve's Focus on PCE

While the CPI has garnered a lot of attention recently, it's important to note that the Federal Reserve does not rely heavily on this metric when making decisions about interest rates. Instead, the Fed focuses on the Personal Consumption Expenditures (PCE) index, which measures changes in the prices of goods and services consumed by households.

The PCE is considered a more accurate reflection of inflation, as it takes into account changes in consumer behavior and substitution patterns. Additionally, the Producer Price Index (PPI), which measures the average change in prices received by domestic producers, can provide early indications of future PCE readings.

The Spread Between 10-Year Treasuries and 30-Year Fixed Rates

Another crucial factor to consider when assessing the potential for mortgage rate drops is the spread between 10-year treasuries and 30-year fixed rates. Traditionally, the 30-year fixed rate has been about 1.5 percentage points higher than the 10-year treasury yield.

However, in recent years, this spread has widened significantly, reaching as high as 3.5 percentage points in 2022. This widening spread has made mortgages more expensive for consumers, even when treasury yields have remained relatively low.

The good news is that the spread has started to evaporate, with recent data showing a decrease from 3.25 to 2.5 percentage points. As the market stabilizes and overreactions subside, there is potential for the spread to return to its historical norm of 1.5 percentage points, which would lead to lower mortgage rates for consumers.

Bottom Line

While the recent CPI shock has caused concern among market participants, there are still reasons to be optimistic about the future of mortgage rates. The flawed shelter cost component of the CPI, the Federal Reserve's focus on the PCE, and the narrowing spread between 10-year treasuries and 30-year fixed rates all point to the potential for lower mortgage rates in the coming months.

As the market continues to digest the recent data and adjust to the new reality, it's essential for consumers and industry professionals alike to remain informed and adaptive. By understanding the complex factors driving the economy and interest rates, we can make more informed decisions and navigate the ever-changing financial landscape with greater confidence.