Mortgage Rates and Inflation: The Real Story By NAR Economist Danielle Hale

When reading news articles on housing and mortgage rates, you'll hear a lot of talk about whether rates are up or down. If you read a well-written article, the writer will also mention inflation, but rarely will the author tie both together in a meaningful way. Unfortunately, what is often ignored is what really matters: real interest rates.

Real interest rates are is the nominal interest rate or the interest rate that is quoted in the market minus the inflation rate. This is the lender's true rate of return on investment after accounting for the loss in purchasing power from rising prices.




In the above figure, we see expected real mortgage rates declined gradually from 2000 until 2004 where they stabilized for a time around 2.5% to 4%. (Four separate inflationary expectation assumptions are applied, but all show similar trends). The real mortgage rates then began to rise from mid-2005 to mid-2007 before they began to fall again. Even as nominal rates have ticked back up in the last few days, real rates, those that incorporate expectations about inflation, are well below the average for the decade.

This is why some economists like Allan Meltzer, with whom I was fortunate to have worked with at a think tank, have criticized the Federal Reserve for responding as it has to those calling for further rate decreases. Cutting rates when real rates are already low puts the economy at risk of inflation and diminishes the Federal Reserve's independence to pursue its long run objective of price stability. As Dr. Meltzer discovered, once an inflation has started, it is difficult to end and even more painful to convince market participants that it is credibly over.

Fortunately, mortgage rates have been relatively low and stable, despite inflation's acceleration to 4.1% over the recent 12 months. Market participants are evidently discounting the current high inflation as a fluke that will soon go away. However, recent inflation rates have been unexpectedly higher than what was forecast. Anytime there is unexpected inflation, borrowers are paying lower real rates and benefiting at the expense of lenders. Lenders do not like this inflation surprise and will begin to tack on additional "inflation risk" to interest rates. Once that happens, long-term interest rates including mortgage rates will rise and begin to choke markets until participants demand an end to the inflation. The only way to kill inflation-once out of the bottle - is for the Fed to sharply raise interest rates. The resulting pain for borrowers and, hence, for the housing market will be the price paid if the Fed's commitment to price stability ends.

The Fed is poised to cut rates in the next FOMC meeting on March 18th possibly by even 75 basis points. The rate cut is partly being justified based upon Fed's projection of decelerating inflation over the next two years. It is, nonetheless, vital for the Fed to communicate clearly that it will immediately tackle inflation and act on that promise irrespective of economic conditions if market participants begin to form notably higher inflationary expectations. Or else … the housing market will suffer the consequences.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS