Introduction

In the changing landscape of the economy, one of the key factors that homeowners and potential homebuyers need to keep a watchful eye on is inflation and how it impacts mortgage interest rates. Inflation is defined as the increase in the overall price level of goods and services in an economy. Because it influences the cost of borrowing money, inflation can have a significant impact on various aspects of our financial lives. One area where its influence is particularly pronounced is in the realm of mortgage rates. In this article, we will discuss the relationship between inflation and mortgage rates, exploring how changes in inflation can send ripples through the housing market.

The Basics of Inflation

Before we talk about how inflation affects mortgage rates, it is important to understand the basics of inflation itself. Inflation is measured in several different ways by economists, market participants and the Federal Reserve Bank (The Fed). Two different price indexes are popular for measuring inflation: the consumer price index (CPI) from the Bureau of Labor Statistics and the personal consumption expenditures price index (PCE) from the Bureau of Economic Analysis. Each of these is constructed for different groups of goods and services, most notably a headline (or overall) measure and a core (which excludes food and energy prices) measure.

An accurate measure of inflation is important for both the U.S. federal government and the Fed, but they focus on different measures. For example, the federal government uses the CPI to make inflation adjustments to certain kinds of benefits, such as Social Security. In contrast, the Fed focuses on PCE inflation in its quarterly economic projections and states its longer-run inflation goal in terms of headline PCE. The Fed focused on CPI inflation prior to 2000 but, after extensive analysis, changed to PCE inflation because they felt that it gave a more accurate picture of inflation.

The Federal Reserve’s Role

The Fed plays a pivotal role in attempting to manage inflation in the United States. The central bank utilizes a variety of tools to control inflation, with the federal funds rate being one of the most influential and well known. By adjusting the federal funds rate, the Fed can stimulate or cool down economic activity, influencing inflation levels. Keep in mind that moving the federal funds rate, in and of itself, only directly changes the overnight lending rate among US Banks. However, by changing the federal funds rate, the Fed signals to market participants and the banking system a desire to increase the overall level of rates and slow down the economy to decrease inflation. An increase in the federal funds rate will often incent investors to sell longer term Treasury bonds and mortgage-backed securities so that the rates of longer-term bonds go up.

In addition to moving the federal funds rate, the Fed can also influence inflation by buying and selling longer term bonds like Treasury Securities and mortgage-backed securities. When the economy was sluggish or faced a shock to the system (e.g., 2008 financial crisis, COVID-19 pandemic, etc), the Fed implemented Quantitative Easing where it bought Treasury bonds and mortgage-backed securities. By purchasing these bonds, the Fed increased the supply of money to provide liquidity to the banking system and encourage banks to lend money at lower rates. By purchasing a massive amount of long-term bonds, the Fed increased the demand for Treasuries and mortgage-backed securities which increased their prices and decreased long term rates. Now that we are facing inflation, the Fed is doing the opposite by not buying new bonds when these Treasuries and mortgage-backed securities mature. By not buying additional bonds, the prices of these bonds are falling which is causing the interest rates for long-term Treasury bonds and mortgage-backed securities to go up.

Mortgage-backed Securities

Mortgage-backed securities consist of a group of mortgages that have been organized and securitized to pay out interest and principal like a mortgage bond. Mortgage-backed securities are created by companies called aggregators, including government-sponsored entities such as Fannie Mae or Freddie Mac. They buy loans from lenders, including big banks and mortgage brokers, and structure them into a mortgage-backed security.

Think of a mortgage-backed security like a giant pie with thousands of mortgages thrown into it. The creators of the MBS may cut this pie into potentially millions of slices — each perhaps with a little piece of each mortgage — to give investors the kind of return and risk they demand. Mortgage-backed securities typically pay out to investors monthly, like the mortgages underlying them. When the prices on mortgage-backed securities go down, the yield (or rate) on the bond goes up.

Because most mortgage originators (banks, brokers, etc) sell their mortgage loans to aggregators who structure them into mortgage-backed securities, an increase in the yield (or rate) of the mortgage-backed security will directly impact the mortgage rate that the originator is willing to offer to the consumer.

Inflation and Mortgage Rates

The relationship between inflation and mortgage rates is not always straightforward, but there are some general trends that can be observed. Mortgage rates are influenced by various economic factors, and inflation is a significant player in this intricate dance.

1. Interest Rates and Inflation

One of the primary channels through which inflation impacts mortgage rates is the effect it has on overall interest rates. Inflation erodes the purchasing power of money, prompting central banks like the Fed to raise interest rates to keep inflation in check. When interest rates rise, the cost of borrowing increases across the board, affecting everything from credit cards to mortgages. Most mortgages are financed in the debt capital markets by mortgage-backed securities. When the interest rate on mortgage-backed securities goes up, the lender passes this cost on to the consumer by increasing their mortgage rate. This uptick in mortgage rates makes it more expensive for consumers to finance a home purchase or refinance an existing mortgage.

2. Inflation Expectations

It’s not just current inflation rates that influence mortgage rates. Expectations for future inflation also play a crucial role. Lenders and investors assess economic conditions and make projections about future inflation trends. If there is an expectation that inflation will rise in the future, investors in mortgage-backed securities may sell their bonds to buy securities with higher rates of return. This causes bond prices to go down which will move the rates on mortgage-backed securities up. Because mortgage lenders fund most of their loans through mortgage-backed securities, an increase in the rates for mortgage-backed securities will be passed on to consumer in the form of higher mortgage rates. Conversely, if inflation is expected to remain low and stable, the rates on mortgage-backed securities will remain low which keeps mortgage rates low. Managing inflation expectations becomes a delicate balancing act for the Fed, as changes in perception can have tangible effects on mortgage rates.

3. Real Interest Rates

Real interest rates, which account for inflation, provide a clearer picture of the cost of borrowing. When inflation is high, even if nominal interest rates are elevated, real interest rates may not increase as much. However, if inflation outpaces interest rate adjustments, real interest rates may effectively be lower, potentially stimulating borrowing and spending. For homeowners, understanding real interest rates is essential for making informed decisions about mortgages. It helps them gauge the true cost of borrowing and assess whether locking in a fixed-rate mortgage or opting for an adjustable-rate mortgage is a more prudent choice.

Conclusion

Inflation’s influence on mortgage rates is a multifaceted and dynamic relationship that requires a nuanced understanding. As homeowners and potential buyers navigate the complex landscape of real estate, keeping an eye on inflation trends and their potential impact on mortgage rates is crucial. The interconnected nature of the economy means that changes in inflation can send ripple effects through various sectors, influencing interest rates and, consequently, the cost of homeownership.

Staying informed about economic indicators, central bank policies, and inflation forecasts can empower individuals to make informed decisions about their mortgage financing. Whether you’re a first-time homebuyer or a seasoned homeowner considering a refinance, being aware of the interplay between inflation and mortgage rates can help you navigate the waves of the housing market with confidence.