The Fed Funds Rate and Its Impact on Prices with Doug Duncan | PART 1 #842

Douglas G. Duncan is Senior Vice President and Chief Economist at Fannie Mae where he is responsible for forecasts and analyses of the economy and the housing and mortgage markets. Duncan also oversees strategic research regarding the potential impact of external factors on the housing industry. He leads the House Price Forecast Working Group reporting to the Finance Committee.

Under his leadership, Fannie Mae’s Economic & Strategic Research Group (ESR) won the NABE Outlook Award, presented annually for the most accurate GDP and Treasury note yield forecasts, in both 2015 and 2016 – the first recipient in the award’s history to capture the honor two years in a row. In addition, ESR was awarded by Pulsenomics for best home price forecast.

Named one of Bloomberg/BusinessWeek’s 50 Most Powerful People in Real Estate, Duncan is Fannie Mae’s source for information and analyses on demographics and the external business and economic environment; the implications of changes in economic activity on the company’s strategy and execution; and for forecasting overall housing, economic, and mortgage market activity.

Prior to joining Fannie Mae, Duncan was Senior Vice President and Chief Economist at the Mortgage Bankers Association. His experience also includes work on the Financial Institutions Project at the U.S. Department of Agriculture and service as a LEGIS Fellow and staff member with the Committee on Banking, Finance, and Urban Affairs for Congressman Bill McCollum in the U.S. House of Representatives.

Duncan received his Ph.D. in Agricultural Economics from Texas A&M University and his B.S. and M.S. in Agricultural Economics from North Dakota State University.



Narrator  This is The Norris Group’s real estate investor radio show the award-winning show dedicated to thought leaders shaping the real estate industry and local experts revealing their insider tips to succeed in an ever -changing real estate market hosted by author, investor, and hard money lender, Bruce Norris.

Bruce Norris  Hi  thanks for joining us. My name is Bruce Norris  and once again we are joined by Doug Duncan, who’s the Chief Economist of Fannie Mae been with us many times and really a friend of our business for a long time. Doug is Senior Vice President and Chief Economist at Fannie Mae where he’s responsible for forecasts and analysis of the economy and the housing and mortgage markets. Duncan also oversees strategic research regarding the potential impact of external factors on the housing market, is if there is any. Doug is a Fannie Mae’s source for information and analysis on demographics, and the external business and economic environment, the implications of changes in economic activity on the company strategy and execution and for forecasting overall housing, economic and mortgage market activity. Duncan received his PhD in agricultural economics from Texas a&m University is BS and MS in agricultural economics from North Dakota State University. And instead of choosing farming, he chose statistics. So we’re glad. We’re glad you’re back, Doug, how you doing?

Doug Duncan  I am well, I’m happy not to be under the business end of a Holstein.

Bruce Norris  Ah. That’s true. You know, it’s funny when I first house we actually bought had a third acre of land. And we thought were gonna use, we, I raised a cow, two pigs. It was crazy. Yeah. I learned I didn’t want to do that anymore, but.

Doug Duncan  I enjoyed being in the field, but not so much under the animals.

Bruce Norris  No, that was an interesting experiment. Well, I kind of wanted to start, I think back when inflation, you know, when I was a young adult, I was involved in that. And I, of course, I had no clue what I was watching. But I did get involved in it. Because at the time, I had just gotten married, and I bought a home. And it was very volatile. So if I bought a home in 72, by 1980, the world had changed of everything attached to real estate. And so you know, like I took over a 5% loan, and I refinanced it to become a real estate investor at 17 and a half, that’s a heck of a move. Eight years of time, you know, and all the volunteers in between, I used to work at a hardware store. And we literally had to change prices of items during the week. Because if we didn’t do that we were going to sell and buy it for more from the supplier. So we had to constantly be aware of what was this gonna cost us tomorrow. So we get into with a profit, not just another plug. So that was my vision of, you know, watching the actual impact of of inflation. But going back to, let’s say, go back to 72, inflation was sort of pretty calm. It was about three and a half. Now, was there was there a target back then that that made them concern?

Doug Duncan  No, that’s a more recent phenomenon that the Fed would actually suggest that there was a level that they found optimal. That’s post 1980. Post Volcker timing.

Bruce Norris  Okay.

Doug Duncan  So you’re right, inflation was relatively low in the early 1970s. And then we went into the Vietnam War, and the spending related to that and some other factors. My lack of monetary discipline led to, as you noted, very significant levels of inflation and therefore nominal interest rates.

Bruce Norris  Was the word transitory, invented later or during that timeframe.

Doug Duncan  The word transitory was invented while the word itself I’m not sure if its origins, but it’s used in terms of describing supply impacts on inflation is of very recent origins, basically about a year ago or a little more than maybe a year and a half ago.

Bruce Norris  Okay. So we didn’t hear that word back in the 70s.

Doug Duncan  You did not, you heard monetary theory that inflation is everywhere and always a monetary phenomenon and monetary policy x with long and variable lags. Those were have been the terms you would have heard, driven largely by the thinking of milk Friedman at the University of Chicago, right? And actually, I had lunch with Paul Volcker, oh, maybe six or seven years ago, he has, of course, passed by now. But I asked him something about the Phillips curve, which is a Keynesian construct. And he looked at anyone that was just credited 30 years ago.

Bruce Norris  That’s pretty much how he sounds probably.

Doug Duncan  Said he, was he said, Oh, yeah, you’re the mortgage guy.

Bruce Norris  Oh, that is pretty funny. Well, when inflation started edging up, it was like 74, we went from pretty calm at three and a half to 11 for 74. But then it kind of calmed back down for 75 to 77, in the five to six range. And so what made that turn around was were interest rates aggressively raised and it backed it off?

Doug Duncan  They were not aggressively raised. That’s why it didn’t come back down to the three and a half percent, or whatever that level, I’d have to go back and look at monetary measures, that is measures of cash essentially, in the economy to see what they were doing. But one of the issues was that the Chairman of the Federal Reserve at that time, was maintaining an easier money policy that is more liquidity provided to the market than last. And that was underpinning the growth of inflation. Whether it tips back a little bit at a particular point in time is a more a matter of timing in some instances, for example, right now, you can see the headline numbers of inflation are coming down, because they’re being compared to higher numbers a year ago.

Bruce Norris  Right, right.

Doug Duncan  Economists call that the base effect. But it’s it’s depends on what time period you’re comparing to what you think the growth rate is, that’s going to reverse itself in the not too distant future in the next two or three months. And then you may well see inflation coming back up again, based on the base of comparison at that time. That’s one of the reasons that Chairman Powell was really loath to use the term pause. If you watched his press conference recently, he didn’t he never use the word pause. He just simply said they’re going to stop raising rates at the moment. And then in the directive, in the release, said that they would monitor incoming data.

Bruce Norris  Okay, so he’s expecting that inflation may kick forward together.

Doug Duncan  That’s certainly a possibility.

Bruce Norris  Categories, it’s that’s probably not real estate related, which is a big category.

Doug Duncan  It is not. In fact, we know that the real estate numbers will in fact, be one of the things that brings the core inflation down because of the way that it’s embedded in the inflation metrics. To me, what Powell is saying is reflective of his knowledge of Paul Volcker’s experience in 1980. And through 1982. Volcker was appointed in 1979, he immediately moved on monetary aggregates to start the process of this inflating the economy. It started a recession in January of 1980, that ran through July. And some of those inflation numbers came down a bit. And so they slowed or eased a bit, but immediately got a burst of inflation again, so they had to tighten even more strongly. That led to a recession of 18 months, a very serious recession of 18 months. That’s called, that was the the action that caused people for subsequent years to talk about double dip recessions, because there were two dips. So, that’s the that’s what they’re referring to, is those early Volcker years. What one of the things that Powell does not want is a double dip recession. Part of the reason that he’s not yet ready to say that they have paused he’s not yet ready to say they’re pivoted is waiting to see the response of inflation and the possibility that as I just mentioned, with the base effect, you start to see a headline increase inflation in the next two or three months. The other thing that he’s working against is what’s called the Greenspan put, which was the statement that Greenspan said made about bubbles. He said, paraphrasing, obviously, we, we don’t know when exactly we’re in a bubble. So we don’t know whether to prick the bubble. But we do know when it does explode, we can cushion the market on the downside. So what’s happening today is the market is encouraging the application of the Greenspan put, which was a course supported by Bernanke and Yellen as well. And so he’s trying to get both of those phenomena out of the market. And that’s a difficult task.

Bruce Norris  Yeah. Back in the 70s, to 1980, did the did the Fed have a balance sheet that was full of the assets like it is now?

Doug Duncan  Nothing like today, this is a modern innovation, you’d have to go back to earlier than I think in 1952, there was an accord signed between the Treasury Department and the Federal Reserve, that ended the World War II process of the Fed, holding treasuries on balance sheet to support the financing of the war. So they actually, it’s called the Fed Treasury accord of 1952, where they said, we will no longer do that.

Bruce Norris  Was Volker, would Volcker be shocked that the asset mix on the Fed balance sheet today?

Doug Duncan  I believe he would, I don’t believe he would none. This is obviously just Doug’s view. But I don’t believe especially in the case of mortgage backed securities, that he would have agreed to put those on balance sheet because that shows a preference for one particular asset group, and raises the question from all the other asset groups of why not us. And that’s part of the reason the Fed stays in treasuries, is that that’s a national obligation.

Bruce Norris  What’s the practical outcome of putting mortgage backed securities on the Fed’s balance sheet? Does it just make interest rates stay low, or even lower than the market would have allowed it to go?

Doug Duncan  That is, that’s correct, because the Fed would not be able to purchase them if someone wasn’t willing to sell them to the Fed at that yield, right. The Fed is a policy buyer. They’re not an economic buyer, by which I mean, their intention was to intervene in the market to change its pricing, as opposed to purchasing it based on expected risk adjusted earnings. So, it’s a policy buyer, it’s intending to disrupt the pricing in that space, not buying to, to, for investment purposes and earnings.

Bruce Norris  Well, I was just, I was just trying to think through their cost of funds to buy a mortgage is is zero.

Doug Duncan  Essentially.

Bruce Norris  Okay? And the cash flow that comes from that goes?

Doug Duncan  It eventually gets rebated back to the Treasury.

Bruce Norris  Okay, so it’s if it’s a profit, it goes to the Treasury.

Doug Duncan  Right.

Bruce Norris  Okay.

Doug Duncan  And if it’s a loss, it’s really the Federal Reserve actually is a, it’s essentially an inter government transfer of funds one direction or the other. If, for example, they were to sell their mortgage backed security portfolio, they would recognize a loss, but they would put it on their balance sheet as a contra asset.

Bruce Norris  If they, okay, so unwinding this balance sheet. Is that in the cards? Is that ever going to go back to a reasonable number?

Doug Duncan  They have issued an explicit policy statement stating that they wish to let the entire portfolio of mortgage backed securities run off and not replace it. That is, as you can see that on their website, they have a policy statement that says that is their policy, that so they are currently allowing up to $35 billion per month of mortgage backed securities run off, but of course, nothing close to that is happening because the hidden coupons in their portfolio, like 90% of them are under 4%. And people are not prepaying those mortgages.

Bruce Norris  No. But can the Fed get rid of it anyway by just taking a loss on the paper?

Doug Duncan  They could they could sell it but a question is, would how would they think about the optics of that given that there are some banks which have failed that were heavily invested in mortgage backed securities, that would raise questions about the Fed and people would not understand the mechanics of the intergovernmental transfers that are taking place. And there is concern in the market today already about the size of the portfolios that have to be sold from the banks that were taken into foreclosure.

Bruce Norris  Well, it’s a little ahead schedule, but why don’t we talk about the bank issues, because it sounded, it sounded great when we had all these years of low interest rate loans. But when you’re a bank, so let’s like that the big one that went out in Northern California, they’re required on certain types of assets, part of them are very conservative. Once a 10 year T-bill and things like that, when you have a bunch of those at 1%, and then your 10 year T-bills goes to three or four. Is it mandated that they have to recalibrate what in fact that is worth at today’s value? Or can they just say, we’re not selling it for 10 years? So what’s the difference?

Doug Duncan  Yes, they have a choice, depending on how they’re managing their bank, to list securities in an account that is held for sale, or in an account that’s held for investment. So, if it’s in an account that’s held for sale, it has to be marked to market at all times. If it’s in an account held for investment, it does not have to be marked to market. And you’re absolutely right, the that period of administered very low interest rates, created incentives when juxtaposed to the capital rules that banks operate under, for them to hold significant quantities of both mortgage backed securities and treasuries. So the capital rules view those as having very low credit risk. And so the capital required to hold those from a credit risk perspective is actually very low, creating a strong incentive for them to hold those securities. What that does not do is counter the interest rate risk that they take on where to your point, they have very low yields when they purchase them, and then when market rates rise, the value of those assets declines due to interest rate risk.

Bruce Norris  So, what okay, just this is an honest question from somebody not not really understanding. So if they bought a million dollars worth of 10 year T-bills that 1% was a million dollars us to do that, or was their leverage is to do that.

Doug Duncan  Never would have been a million dollars used to do that.

Bruce Norris  Okay, so they just don’t do melt, right.

Doug Duncan  Right. Yeah.

Bruce Norris  But the problem with the bank, so they had to kind of people got afraid. And so they started saying I’ll take my deposit out to take my deposit out that got so large that they, did they have to force sell some of those assets? Is that what happened?

Doug Duncan  Well, well, initially, it wasn’t that people were afraid it was that money market mutual funds were paying 4% interest or more, and banks are paying a quarter of a percent. And so the incentive for people to move their funds to higher earning became very strong.

Bruce Norris  Right.

Doug Duncan  Now there is one thing to note in there. And that was a policy change by the Federal Reserve, which opened a program called the reverse repurchase window, where mutual funds could park security investments with the Federal Reserve, in return for cash and take that money out of the banking system. Prior to that window, the if you had money in a mutual fund, that mutual fund had money in a bank. So if you withdrew the money from the mutual fund and put it in a different one, it was just moving money around the banking system. This actually offered the opportunity to take it out of the banking system. So it became a more significant challenge to liquidity for those banks who had to attract deposits to fund the lending and securities purchases that they do.

Bruce Norris  Okay. Do you feel like what we’ve seen so far is the bulk of the damage to the banking system, or is this contagious?

Doug Duncan  Well, I always remind people It was almost six months to the day, between the time that Bear Stearns failed, and Lehman failed. So, it’s often take some time to understand how where in all of the plumbing in the banking system, the problems might reside. So I’m not ready to suggest that the issues are over yet, we have learned two or three pretty important things. One is there’s a class of banks that are too big to fail. There’s about a dozen or so banks that clearly the government will not allow to fail. And so the hot money, which is the very large deposits, typically from businesses moved very quickly to those banks. And those banks weren’t paying yields of interest, they were paying security, and money went to those banks for safety. The rest of the banks are not too big to fail. And so people started looking at where the investments were of those banks, which are not too big to fail, it fell under the title of regional banks, although some of them were local, some were regional. And they recognize that the majority of the commercial real estate loans resided in those banks, and also, a significant share of the commercial and industrial loans also read it resided at those banks. And there’s a question about the health of the commercial real estate space, particularly offices, work from home and all of that. So that raised the second set of issues. But it’s important to point out that those banks were actually better at making those kinds of loans that were unique to the communities that they serve, than the big banks were otherwise the loans would have already been in the bank bank portfolios. So there’s an important policy thing to consider here. When you think about the nature of our banking system, and how different segments serve different needs, within the economy, that’s kind of getting lost in the discussion. And I’m very concerned about this, the issue that we do have some banks who do not serve local markets, well, that are considered too big to fail, and therefore have a capital advantage, a cost of capital advantage over institutions not viewed as too big to fail. So there’s some very important policy questions here.

Bruce Norris  Let’s take a look at the office space just for a second. So that’s mostly local or regional banks. And let’s say in the case of office space, people, first of all, those loans are fixed for a short period of time.

Doug Duncan   Yeah

Bruce Norris  So it’ll get 30 year fixed rates, you have, like, I think a trillion and a half dollars of those coming due in the next two years. Yeah. So when that comes due the lender, you know, in the residential, we’re used to the term cash out refi. And in the commercial world, they’re going to be used to the cash in refi.

Doug Duncan  That’s, likely to happen, they’re gonna have to either the valuation on those properties will have fallen, based on the expectation that occupancy will be lower because of the work from home move.

Bruce Norris  And the rent could be less.

Doug Duncan  That’s exactly right.

Bruce Norris  And the cap rate could be less because of the interest rate rise.

Doug Duncan  That Well, yeah, the cap rate will depend on what happens with revenues. So the cap rate is the net operating income divided by the price. And so if prices fall, and net in net operating income fall, then the cap rate may stay constant, but the valuation of the full operation will fall. And so if they’re going to refinance, if they had a 10 year bullet loan that comes due you have to reap, refinance it at a lower value, either you have to bring money to the table, or you can sell the property and take a loss.

Bruce Norris  Or you can give it to the bank?

Doug Duncan  Or you could give it to the bank.

Bruce Norris  That’s correct. In the office building that we bought. So this is my history of office space. It was it was illuminating. Honestly, it sold for about a million dollars before we bought it for 319,000. So we bought it for a third because it was vacant, as was about 80% of the complex. It was in A-structure but just nobody to fill it. There was a building behind us that was vacant for eight years. It had a tenant finally that guy bought the building from me for a million dollars, you know a year ago So, so that is a very volatile asset class in a sense, because if I don’t have anybody in my building, what are the odds of me getting a refi?

Doug Duncan  Right, zero.

Bruce Norris  Zero. Okay, wow. Yeah, that’s really interesting. Okay. Well, I’m glad I don’t currently own an office building. The so the Fed right now, let’s go back a year, May 2022. We have a quarter percent federal funds rate about how long had it been in that range?

Doug Duncan  Oh, gosh.

Bruce Norris  Like a decade?

Doug Duncan  Yeah, roughly a decade, we did see a rise in the fed funds target in 2017 18. And then, in 2019, we eased as the economy was slowing a bit. And then of course, the pandemic hit in 2020.

Bruce Norris  Yeah.

Doug Duncan  We did have a period in there where it was up to about 3%.

Bruce Norris  What was your thought about prices? Let’s say in 2019, for real estate, did you see, did you think, okay, we’re about done for the cycle. Where did you say now we’re, we’re going to crank.

Doug Duncan  Well, interestingly, in the fourth quarter of 2019, we had a discussion about that we, as the forecast team, had a discussion, we saw some signs of slowdown in the economy, going into the first quarter, we had a discussion about whether we should consider a recession, or simply an easing by the Fed in the middle of 2020. Now, that was all before the pandemic, of course, pandemic he had an all of those thoughts had to change to some other things. But we we do have notes that show that we were giving thought to whether or not there would be a recession in 2020 have a mild nature. But why say mild nature, because we were still in the camp, that supply was the problem in housing, we had entered that category of thinking back in 2014. We had become concerned that with the rise of the millennials, that the building business took such a huge hit in the meltdown that it was going to be a long time to recover. So, you know, we saw an impact in 2013. From the how the market was going to respond to the Fed not adding to its portfolio of MBs. And that was called the taper tantrum right when Bernanke made his speech, just the thought that they would stop buying MBS drove mortgage rates up a full percentage point. So we were weighing that consideration because they again started to run the portfolio not only stopped buying, but started to run the portfolio off in 2018 and 19. Rates again went up about 100 basis points based on that change. So it validated for us that we didn’t have the full information that market pricing normally would give you because of the interventions of the Fed. And there, we didn’t know how withdrawing their intervene mentions would change the base economic facts, but it looks to us like it was weakening the economy, and we should consider whether there would be a recession.

Joey Romero  Well, that’s gonna do it for this week’s episode. Be sure to tune in next week for part two of our interview with Doug Duncan, Chief Economist of Fannie Mae.

Narrator  For more information on hard money, loans and upcoming events with the Norris group, check out the Norris For more information on passive investing with trust deeds, visit tng trust

Aaron Norris  The Norris Group originates and services loans in California and Florida under California DRE License 01219911, Florida Mortgage Lender License 1577, and NMLS License 1623669.  For more information on hard money lending, go and click the Hard Money tab.




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