Homebuyers may finally get some relief in the new year as mortgage rates are expected to drop below 5% on the back of cooling inflation, according to a mortgage expert.

In an interview with CNBC, Mortgage News Daily’s chief operating officer Matthew Graham cited the “staggering” drop in mortgage rates last week after the Fed signaled that interest rates would likely fall in 2024.

The 30-year rate declined by almost 20 basis points to 6.64% between Dec. 13 and 14—one of the biggest two-day moves we’ve seen,” Graham said.

The Fed influences the mortgage market indirectly by setting short-term interest rates that banks charge each other. When the Fed's rates rise, mortgage rates typically follow (and vice versa).

“The rate momentum is as good as the trajectory of economic data,” Graham said. “If the data continues to do what it has been doing, there’s no reason rates couldn’t go down into the fives, possibly even high-fours.”

But even before the Fed plotted its latest rate trajectory, average mortgage rates were in a steep decline from their 22-year peaks in October. According to Freddie Mac, average 30-year rates have declined for seven consecutive weeks, from a high of 7.79% to 6.95%.

Graham believes interest rates could fall even further if the economy dips into a recession.

The Fed’s (expected) path

Graham isn’t the first industry expert to predict a decline in rates. In November, Creditnews reported a chorus of experts predicting that mortgage rates had likely peaked based on signals in the bond market.

At the time, the 10-year U.S. Treasury yield had fallen by roughly 40 points from its recent peak. Fast forward to Dec. 19, and the yield is down more than 100 points.

That brings us back to the Fed. In September, Fed officials penciled in one more rate hike in 2023 but never followed through because Treasury yields were doing much of the heavy lifting in fighting inflation.

“Financial conditions have tightened significantly in recent months, and longer-term bond yields have been an important driving factor in this tightening,” Fed chair Jerome Powell said in October.

Based on the Fed’s revised outlook, interest rates will fall by 75 points in 2024. That’s equivalent to three rate cuts—assuming a 25-point reduction each time.

Futures traders think there’s a 75% chance the central bank will make its first rate cut in March, according to CME Group’s FedWatch Tool.

Will housing affordability improve?

Lower mortgage rates can help thaw the housing market by making financing more affordable. But will it make housing more affordable?

When it comes to housing affordability, mortgage rates are just one part of the equation. The other part is home prices.

Since the pandemic, the average price of a U.S. home has jumped by more than $100,000. And while home prices are down from their peaks in 2022, they still remain too high for many first-time buyers.

Technically, more affordable financing should boost demand for housing. But according to Creditnews Research, that's not always the case.

Since 1970, home prices have fallen nearly half the time when the Fed cut interest rates, including the post-1970s inflation cuts between 1981 and 1983.

That's because falling rates usually coincide with a recession, and more affordable financing doesn't always fully offset the economic hardship of it.

At the end of the day, home prices are a function of demand and supply—the latter of which is at the lowest level relative to demand in America's history.

According to the St. Louis Fed, there’s 3.6 months’ worth of housing inventory at the current sales pace. That’s well below the 5-6 months of supply needed for what is considered a healthy market.

Experts estimate that the U.S. needs an additional 6.5 million homes to fill the gap. Will the housing shortage keep shoring up home prices? Unfortunately, history provides little guidance on this matter.