What is Inflation?Inflation is essentially the rise in CPI over time. Over the last few decades, inflation has typically averaged below 3%. Over long periods of time, 3% inflation can significantly erode the purchasing power of consumers. At 3%, the value of a dollar is halved in 24 years or, in more basic terms, that $1 candy bar at the checkout counter would cost $2, 24 years later. And, at 8.5%, it would take 8 ½ years for the candy bar to double in price. One of the goals of the Federal Reserve is to help ensure stable prices by limiting inflation. The Federal Reserve uses several tools to accomplish this, among these is the targeted federal funds rate. When the economy is too strong, the federal reserve will raise rates to reduce lending and thereby slow the economy and inflation and when the economy is too slow, it will lower rates to spur lending and thus speed up the economy. The federal funds rate also has an impact on the rates used by banks to lend money in the way of credit cards, auto loans, and mortgages. The relationship between inflation and the 30-year mortgage is pretty strong. The St. Louis Federal Reserve graph below uses the 30-year mortgage rates (blue line) and annual inflation (red line) since 1970. As inflation increases, rates charged on mortgages also tend to increase and as inflation declines, rates also decline. This similarity in movement is measured in mathematical terms called correlation. There are several periods where there are disconnects, such as during the 2008-2009 Great Financial Crisis and mid-1980s energy crisis, but over the long run this relationship holds well. The below graph adds the targeted Federal Funds rate (green). The Federal Funds rate has a higher correlation to mortgage rates. This means that Federal Funds rates and mortgage rates tend to move in similar directions. The current target Federal Funds rate is 0.50% and the implied rate for January 2023, according to Bloomberg, is 2.825%. In the last year, mortgage rates climbed to just over 5% from a low of around 2.5%. The Federal Funds rate has increased to 0.50% from 0.25% and is expected to increase at least another 200 plus basis points (200 bps = 2%) to +2.5%. If the correlation holds, and rates do increase as expected, mortgage rates could increase beyond the current 5% level seen today.
Inflation and Mortgage Rate Trends CorrelateHowever, individual mortgage rates are set not just by the Federal Reserve. Lenders consider several aspects when lending money to a potential buyer. Obviously, some of these items are credit score, location, type of home, down payment, use of the home, and so on. The lender, or bank, has a fixed amount of money available and has to do its due diligence to ensure the mortgage is priced according to the amount of risk the lender is taking on. The greater the risk, the higher the rate to compensate the lender in the event of default. If the lender is not pricing the risk appropriately then it will take a loss should it sell the mortgage to another institution. If there are too many losses, the lender will be forced to stop lending and could close its doors. Mortgages are often sold once the loan is made. The mortgages are bundled into pools of mortgages that have similar characteristics called MBS or mortgage-backed securities. When the lender sells the pool of mortgages, it then has additional capital to lend money to create more mortgages. According to SIFMA, as of 1 January 2022, the mortgage market was roughly $12.2 trillion.
How COVID Has Brought on InflationDuring the onset of the pandemic in March of 2020, consumers curtailed spending in certain areas that negatively impacted the economy. State tax revenues fell drastically with only a few states posting higher 2Q20 revenues when adjusted for inflation. Of the 50 states, 7 posted revenues that increased and only 4 had revenue growth above 1%. According to PEW, the other 43 states experienced significant declines, with several states experiencing double-digit declines in tax revenue. The U.S. Treasury and Federal Reserve stepped in with several actions to combat the expected decline and job loss. Among these was to create backstops in the financial markets as well as the introduction of quantitative easing. Congress also authorized several items that directly provided money and tax benefits to households. The combination of these historic measures has kept the economy moving forward but at the risk of increasing the amount of money in circulation. M2 is one measure used to identify how much money is in circulation because it adds cash and deposits below $100,000. The St. Louis Federal Reserve graph below depicts M2 growth on a year-over-year basis and, as seen by the spike, this growth has been extraordinary. At the onset of the pandemic, M2 was just over $15 trillion and today it is nearly $22 trillion. The significant increase in the available money in the market helped keep the economy afloat during the pandemic; however, as the economy continued to open up, the excess money helped create inflation as it chased a limited amount of goods and services. As a result, sellers have increased their prices.
How Does Inflation Affect BorrowersInflation is also being driven by the Russian – Ukraine war. Russia provided nearly 40% of Europe’s natural gas and 25% of its oil. The Russian boycott has resulted in a significant shock to the world’s energy supply. Additionally, Russia and Ukraine supply 25% of the world’s wheat, therefore, the war is also impacting world food prices. Another driver for today’s inflation has been supply chain disruptions. Off-loading of goods shipped from China to the U.S., transporting to the warehouses, and shipped to stores is having problems. The reasons behind the supply chain disruptions are broad and range from wage issues, technology innovation, demand surges, and lack of long-term investment. Even if the war were to end today, the Russian boycott would likely continue for years and the other issues would remain. This makes the uncertainty around interest rates greater. The good news here is that while inflation is high, the expectation is inflation will not continue to be at current levels for too long, but still above the Federal Reserves’ 2-3% target.
Inflation Impacts Home ValuesThe below graph compares the monthly supply of houses with the CPI. The relationship between the two is strong - as inflation increases, the supply of houses begins to also increase. This is because higher inflation pushes the Federal Reserve to raise rates which pushes mortgage rates higher. Traditionally higher rates depress home prices, however, the current limited supply of homes and excessive money (M2) is helping push home prices higher. Fannie Mae expects home prices to increase above 11% in 2022 and 3% in 2023. Trying to time the market on interest rates and prices is problematic. Potential buyers might think they benefit by waiting for rates to go back down to the 2-3% level but the math usually does not work out. Consider two hypothetical buyers: Buyer 1) purchases a $400,000 home with 5% ($20,000) down at 5.0% interest putting principal and interest payments at $2,147. Buyer 2) waits two years for rates hoping rates decline to 3.5% and, using the Fannie Mae expectations, the same home increases in value from $400,000 to $457,320. Buyer two puts down 5% ($22,866) and the payments are $2,054. Buyer 2 might have less of a payment, but Buyer 1 saved over $12,000 in equity and the home appreciated by $57,320 which put Buyer 1 $69,320 ahead. Buyer 1 can also now refinance to lower his/her rate to 3.5%. Refinancing is essentially replacing the current loan with another loan and is typically done to lower the payments or take out some equity saved up in the home. Of course, this all assumes home prices increase as expected and does not consider potential tax savings or the money saved by Buyer 2 as a result not having home repairs. Potential buyers might want to consider down payment options, tax savings, and insurance when buying a home. Renting, while often appearing to be cheaper, does not allow individuals to build potential equity and long-term wealth as the home grows in value over the long term.
What to Expect in the Future for MortgagesIn the current environment, as inflation continues to push above 8%, home prices are expected to outpace inflation over the next two years. Mortgage rates are expected to move higher over the course of the next year. Potential buyers might want to consider their longer-term objectives and identify the best mortgage options and how to get started. Purchasing a home for the first time is a big undertaking and can seem daunting but does not have to be. First-time home buyers have many options available to them to help them get started, from local grants to help with down payments to potential preferred financing options.