Tamer Inflation Means Low Rates
Question: My dad said that in 1981 when he bought his house, the mortgage rate was 15%. Today rates are about half of what they were then. Why?
Answer: The major reason is the taming of inflation.
Economists distinguish between the “nominal” rate of interest and the “real” rate. The nominal rate is the one that is quoted. The real rate is the nominal rate adjusted for inflation. Lenders are concerned primarily with the real rate.
Suppose a lender is willing to lend $100 for a year if he gets back $106. That’s a nominal rate of 6%, and if there is no inflation over the year, the real rate is also 6%. This means that the lender who could buy 100 widgets at the beginning of the year at $1 a widget, could buy 106 at the end. But suppose lenders expect the price of widgets to rise by 5% over the year. Then at 6% the $106 the lender will have at year end would buy barely 101 widgets.
To maintain a real rate of 6%, the lender must raise the nominal rate by 5% to offset the declining value of principal, and by 0.3% to offset the declining value of the interest. The adjusted nominal rate is thus 11.3%. With $113 at the end of the year, the lender can buy 106 widgets at $1.05 a widget.
Q: A few years ago when I was in Suriname, mortgage rates were staggering--36% or more. Why are rates so much higher in some countries than in others?
A: I have already discussed the most important reason. Rates were as high as they were in Suriname because the inflation rate there was high. Countries with high inflation rates have high interest rates.
A second factor that affects mortgage rate differences between countries is the efficiency of the housing finance system. In most respects, the U.S. system is more efficient than those in most other countries. As a result, mortgage rates to prime borrowers in the U.S. are only 1% to 1.5% below long-term government bond yields. In many other countries, the spread is twice as large or more.
Q: The last time the Fed dropped rates by half a percent nothing seemed to happen to mortgage rates. Doesn’t the Fed control mortgage rates?
A: Your sense that nothing happened is based on the stability of mortgage rates after the Fed action. But since the market anticipated this action, whatever impact it had on mortgage rates occurred before the action.
Nonetheless, the impact could have been small because the Fed does not control mortgage rates. The Fed controls the federal funds rate at which banks lend to each other overnight, and the discount rate at which federal reserve banks lend to commercial banks for very short periods.
While short-term rates and long-term rates are related, the relationship is loose. It is not unusual that a large change in short-term rates is accompanied by a much smaller change in long-term rates. Indeed, because short-term rates are much more volatile than long-term rates, this is more the rule than the exception.
Q: What interest rates do I look at to best predict the direction mortgage rates will take?
A: Before the development of secondary mortgage markets, there was an answer to this question. Changes in mortgage rates lagged changes in corporate bond yields by anywhere from two to eight months.
Today, however, the mortgage market is so thoroughly integrated into the broader capital market that mortgage rates and bond yields change together.
A large proportion of all mortgages are placed in pools against which mortgage-backed securities, or MBS, are issued. MBS trade actively in the market and are considered close substitutes for bonds. Any change in bond yields, therefore, is transmitted instantly to the MBS market.
Mortgage loan originators, in turn, base their rates primarily on yields in the MBS market. Originators usually post their rates at about 11 a.m. EST, after they see the opening yields on MBS that morning.
The upshot is that there are no leading indicators of mortgage rates. It is prudent for borrowers to assume that interest rates are as likely to rise as to decline.
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The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com. Distributed by Inman News Features.
