a simple explanation of inflation and mortgage rates

Last week inflation in the United Kingdom jumped to the highest level in two years in February, which prompted concerns because inflation around the globe eventually seeps into the US.  This Monday morning, the Fed’s favorite gauge of inflation the Personal Consumption Expenditures Index was reported higher in February than January.

These reports had a negative impact on Bonds and, as a result, hurt home loan rates. Why? That is because home loan rates are tied to Mortgage Backed Securities, which are a type of Bond. So as Bond prices improve, so do home loan rates. The simple truth is when inflation or just the fear of inflation grows, both Bonds and home loan rates take a turn for the worse. That’s because lower Bond prices are needed to give Bond investors juicier yields that will help out-pace inflation.

Here’s an analogy that helps explain the relationship. Think of inflation as the ocean and interest rates as a boat. As inflation (or the ocean’s tide) rises, interest rates (or the boat floating atop the ocean) have to rise as well. In other words, interest rates (or boats) must always be higher than inflation (or the ocean) in order (stay afloat) to compensate investors.

This is an important topic, and as your Trusted Advisor, I am keeping a close eye on it for you and your clients.