Forecasting 30-year Fixed Mortgage Rates based on Lagged New Housing Starts

RYAN DONNELLY

College of Business

Western Carolina University

Abstract

30-year fixed mortgage rates are forecast to decrease over the next three years.The forecast is based on the Keynesian investment function model.The conclusion was reached by assuming that mortgage rates can be forecast by using lagged new housing starts.As long as people tend to build more house the interest rate on a mortgage will continue to decline. In order for the country to maintain the policy, the Federal Reserve System must keep the interest levels low so our economy can continue to grow.(JEL: E43)

Part 1. Introduction

The purpose of this paper is to forecast 30-year fixed mortgage rates (MORTG) for the years 2000-2002.The explanatory variable is new housing starts (HOUST).The data used to forecast interest rates are monthly statistics from January 1990 to December 1999.The approach for the paper is the Keynesian investment function.

The remainder of the paper is arranged as follows: Part 2. documents the data on MORTG rates and HOUST; Part 3. presents the economic theory of the Keynesian Investment Function; Part 4. presents the forecast for MORTG for the year 2000-2002; Part 5. discuss the economic importance of the forecast; Part 6. addresses effects on economic policy.

Part 2.Data

The MORTG and HOUST data were taken from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED).The data reported on a monthly basis measured in billions of chained 1992 dollars at seasonally adjusted annual rates.

Part 3.The Keynesian Function to Forecast Interest Rates

HOUST cannot change the interest rate by itself, but it can help predict where the interest rate is going.Housing starts still represents a demand for loanable funds.Monthly data for lagged MORTG and HOUST are used to forecast the interest rate over the next three years.The prediction for interest rates will be determined by the Keynesian investment function, which is:

I=f(r)(1.

Inverted the investment function will become:

R=f(I)(2

This simple model will be used to forecast 30 year mortgage interest rates.The rt is the interest rate once the forecast has been made.The function shows that either variable rt-3 or Ht-3 can influence interest rates (rt). The Keynesian Investment Function becomes:

rt = f (rt-3, Ht-3)(3.

Each explanatory variable can change the forecast of the interest rate independently.If, for example, MORTG started to increase, then it would send the forecast to increase or work vice-versa.Now if HOUST started to decline then the interest rate would tend to be lower for it would cause the people to start building, if the HOUST started to increase, then interest rate would rise.

Part 4.Estimates of 30-year Mortgage Rate based on New Housing Starts

The investment function, equation 2, was estimated using monthly data from January 1990 to January 2001.When modified, the equation to handle the lagged MORTG and HOUST written as:

MORTGt = f (MORTGt-3, HOUSTt-3)(4.

When the data was lagged, then the regression results are (with the t-statistics in parentheses):

MORTGt = f (9.529313(-0.05876)*MORTG (-0.00109)HOUST(5.

The regression for the project was only run once on the lagged portions ofthe project.The adjusted R-square for the three-year lagged regression was 5 percent.Now this is the first indication that that there is not a good correlation between these MORTG and HOUST.Housing starts is not a good indicator for predicting interest rates.In TABLE 1, we will see the forecast for the interest rate.

Table 1

Forecast of 30 year Mortgage Rates

DateMortgage Rate

Feb-00
7.46
Mar-00
7.48
Apr-00
7.42
May-00
7.49
Jun-00
7.45
Jul-00
7.52
Aug-00
7.57
Sep-00
7.41
Oct-00
7.44
Nov-00
7.46
Dec-00
7.41
Jan-01
7.46
Feb-01
7.39
Mar-01
7.40
Apr-01
7.43
May-01
7.44
Jun-01
7.33
Jul-01
7.27
Aug-01
7.36
Sep-01
7.41
Oct-01
7.27
Nov-01
7.32
Dec-01
7.18
Jan-02
7.16
Feb-02
7.23
Mar-02
7.22
Apr-02
7.42
May-02
7.31
Jun-02
7.38
Jul-02
7.22
Aug-02
7.26
Sep-02
7.30
Oct-02
7.28
Nov-02
7.26
Dec-02
7.16
Jan-03
7.11
Over the past several years housing starts have been rising and this has caused a decrease in the interest rate.If we can keep the same, then we should have our interest rates going down from now on.The forecast shows a continual decrease in the interest rate over the next three years.The following chart shows the decline in the interest rate.

Chart 1

Forecast of 30 year Mortgage Rate


Part 5. Low Interest Rates in the Future

Interest rates are a good leading indicator of economic activity.Everyone need to have a place to live, and if the 30 year mortgage rate are low, then they will be more likely to spend their money on buying a better house.We can expect to see the interest rates stay around the same level and decline a little over the next few years, except for the occasional rise in interest rates to offset or slow down the economy to combat inflation so it will not get out of hand.The Fed impact long term interest rates by their control over the money supply and setting the interest rate that banks can borrow at to loan to their customers.

Part 6.Forecast Implications

30-year mortgage rates should stay around the same as they are now.A large change in interest rates is not in the picture to make any impact on the future of the economy.They should decrease by about .01 percent each year for the next three years.If this forecast holds true, then we can look at having the next couple of years to be prosperous for the housing industry.This is all because housing starts can be determined by the interest rate.

Reference

Federal Reserve Board of St. Louis, Federal Reserve Economic Data (FRED) http://www.stls.frb.org.fred/