Is it true that rising interest rates are caused by inflation?
Many people identify inflation with increased prices of daily items like gas and bread. Mortgage rates may appear even more detached from inflation. But they’re intrinsically intertwined. Mortgages, like bonds, must climb in interest rates when inflation rises and buying power declines to keep investors interested. Fears of post–COVID inflation are expected to raise mortgage rates in 2021. But how quickly – and how drastically – will both figures rise?
Trends in inflation and mortgage rates
The link between mortgage rates and inflation is clear. It’s clear to observe how mortgage rates and inflation move in lockstep when compared historically. At the time this essay was written, investors who set mortgage rates were worried about potential inflation.
Many experts expect inflation to surge in 2021 because of the COVID stimulus plans and the Federal Reserve’s sustained low–rate policy. This concern alone has driven up mortgage rates recently. Inflation fears have helped kept interest rates from falling too much. What’s going on? And how likely is it that mortgage rates will rise considerably in the near future? Read on to discover the answer.
What exactly is inflation?
Oxford Dictionaries defines inflation as “a general increase in prices and a fall in the purchasing power of money.” In the United States, for example, inflation peaked at 13.55 percent in 1980. In other words, your dollars would have bought 13.55 percent less in 1980 than they would have in 1979. To put it another way, buying the same items would have cost you 13.55 percent more – $113.55 instead of $100. Since 1980, inflation has been falling. It peaked at 5.4 percent in 1990. It has expanded by less than 2% year since 2011. So many of us have forgotten about inflation. But not investors or our central bank, the Federal Reserve.
How does inflation affect mortgage rates?
Inflation affects mortgage rates greatly. The bond market determines mortgage rates. Like 10-Year Treasurys, investors buy bundles of mortgages (MBS) and profit from the interest paid on them. Investing in mortgages is a continuous process.
Mortgage investors are concerned with future returns.
When it comes to inflation, investors have a long memory, as we previously stated. And it’s easy to see why. Assume you purchased a fixed–return asset, such as an MBS or a U.S. Today’s treasury bond. Based on figures for mid–May 2021, you could get a yield (annual return) of more than 2% on MBS and 1.6 percent on a Treasury bond.
If you fear high inflation, avoid long–term fixed–yield assets. Because a 1.6 or 2% yield in 2, 5, or 10 years may not buy anything. Plus, bond yields almost always rise in lockstep. So you could be stuck with a 2% bond for 30 years, when yields could be two or three times higher — or even more. Investors avoid such bonds, raising yields (and borrowing costs). The only way to attract skeptics is to sweeten the package. And if you have a fixed–rate mortgage, your payments will stay the same. If you decide to buy a property or refinance, you may face higher loan rates due to rising inflation.
Do mortgage rates always rise in lockstep with inflation?
Yes, for the most part. Mortgage rates are typically higher during periods of high inflation and lower during periods of low inflation. However, responsible economists rarely use the terms ‘always’ or ‘never,’ because nothing in the world of economic forecasting is ever certain. Things are especially unpredictable during the post–pandemic recovery period. Mortgage rates haven’t always reacted predictably to economic news. And investors and economists are divided on whether we’ll see runaway inflation or, as the Fed believes, only temporary price pressures.