Inflation and Mortgage Rates

As the Federal Reserve tapers its stimulative policies, there's a lot of speculation about the affect this will have on mortgage rates. While the Fed's policies do have an impact, don't lose sight of what might be an even more important determinant of future mortgage rates -- inflation.

Inflation has been unusually tame in recent years, but there are always a number of factors that can set it climbing. How calm inflation remains will have a major impact on how high mortgage rates rise in the years ahead.

Is that Normal?

A look at the historical relationship between inflation and mortgage rates helps define what is normal and abnormal - and underscores that current conditions are decidedly abnormal.

Mortgage finance company Freddie Mac has history on 30-year fixed mortgage rates dating back to the early 1970s. Over the course of this history, 30-year fixed mortgage rates have averaged 8.6 percent. According to figures from the Bureau of Labor Statistics, inflation over the same time period has averaged half of that, or 4.3 percent. So, 30-year fixed mortgage rates generally run about 4.3 percent above the prevailing inflation rate.

This premium of mortgage rates over inflation is not an accident. Mortgage lenders are not going to lend money for 30 years if they expect what they get back to be worth less than what they loaned, so they will charge an interest rate which is higher than the expected inflation rate. This expectation is heavily influenced by whatever the recent trend in inflation has been. So, when inflation goes up, mortgage rates tend to rise as well.

Looking at present conditions, inflation has been running at about 1 percent a year, while 30-year fixed mortgage rates are at about 4.2 percent. This means mortgage rates are only about 3.2 percent above inflation, so there are two things that are clearly out of the ordinary. First, inflation is unusually low, and second, the spread between mortgage rates and inflation is also unusually low.

This second factor probably has a great deal to do with Fed policy.

Where the Fed Comes In

The Fed normally adjusts short-term interest rates in an attempt to moderate economic conditions, but in the persistently weak economy of recent years they have also taken the unusual step of actively buying mortgage-backed and US Treasury securities in order to drive down long-term rates as well. This appears to have been instrumental in pushing mortgage rates to record low levels.

Over the past year, there was increased talk both within and outside the Fed about tapering off those asset purchases. Just the discussion of this possibility helped fuel the rise in mortgage rates seen earlier this year.

Now that the Fed has begun discontinuing those asset purchases, it would be reasonable to expect the spread between mortgage rates and inflation to return to its more normal level of 4.3 percent. With inflation currently running at around 1 percent, that would put 30-year fixed mortgage rates back up to around 5.3 percent.

From the perspective of recent years, 5.3 percent mortgage rates may seem high, but it is still well below the long-term average of 8.6 percent. Keeping mortgage rates from going higher than 5.3 percent may depend on whether inflation remains benign.

Possible Inflation Factors

The problem with counting on low inflation is that there are so many things that can set prices rising. Here are just a few examples:

  • Trouble in the Middle East. Of course, there's always trouble in the Middle East, but when things escalate to the point where it disrupts the oil supply, it tends to be inflationary.
  • Food supply disruptions. Anything from weather events to health scares can cause a jump in food prices, which are an important factor in inflation.
  • International competition. Over the past 20 years or so, international competition heightened by free trade agreements has been instrumental in keeping inflation down. In a persistently weak global economy though, growing protectionism threatens to reverse this process. Also, the high growth rate in developing economies has created another form of competition - a competition for limited natural resources, which could also become inflationary.
  • Labor shortages. With unemployment remaining stubbornly high, it may seem hard to believe that labor shortages could be a factor, but a fast-changing economy can create mismatches between necessary skill sets and the talent pool available. This can cause labor shortages in key areas, which would drive up wages in those areas and result in higher prices.

Barring a dramatic reversal in rates, 2013 will probably turn out to be the first year since 2006 in which 30-year fixed mortgage rates rise. Rather than lamenting the low mortgage rates in the rear-view mirror, consumers should understand that what has happened so far may be just the beginning. The potential for inflation and the spread of mortgage rates over inflation to return to normal could lead to considerably higher mortgage rates. Anyone looking to buy a home, refinance a mortgage, or secure a home equity loan should not delay - history suggests that delays could be very costly.

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