Inflation Readings on the Rise

By Megan Anderson, Vice President of Public Relations

Last year, we began to see widespread inflation, in everything from gas prices to our weekly grocery run. In fact, 2021 marked the highest inflation readings in 40 years. And as we have seen recently, rising inflation can drive mortgage rates higher.

In this article, we will discuss what inflation is, why it is a driver of interest rates, what inflation reports are critical to monitor, why inflation is on the rise, and what to look for as the Fed tries to bring inflation in check so you can help your clients understand what's happening in the markets – and how this could impact their home purchase or refinance this year.

What Is Inflation?

In a nutshell, inflation is too many dollars chasing too few products, which causes prices to be bid higher. If there is an item with high demand, such as a home on the market that has a lot of potential buyers, the high demand will drive the price of that home higher.

Deflation is the opposite. Deflation is where there are too many products and not enough buyers, which drives prices lower. For example, if you have 10 homes for sale on one block and only a handful of interested buyers, there are too many products competing for too few dollars. If you have a large inventory that is not moving, you tend to lower the price to increase demand, which contributes to deflation.

Why Does Inflation Drive Interest Rates?

The first thing to understand is that home loan rates are inversely tied to a type of Bond called Mortgage-Backed Securities (MBS), also known as Mortgage Bonds. When Mortgage Bonds improve or move higher, home loan rates decline. And when Mortgage Bonds worsen or move lower, home loan rates can rise.

Inflation is the archenemy of fixed investments like Mortgage Bonds because it reduces their value. Bonds pay investors a fixed rate of return over time. Inflation erodes the buying power of your future fixed return because the cost of goods and services has increased. Meaning that fixed amount received will purchase less in the future.

For example, let's say you lend someone $100,000 at 4%. Your fixed rate interest only payment is $4,000 per year. Today that $4,000 can purchase a shopping list of goods and services. But over time, prices rise due to inflation so you can’t purchase all of the items on the shopping list with that same fixed amount received. If inflation were to accelerate, the only protection investors have is to increase interest rates so that they receive a larger fixed payment in order to offset the more rapid erosion of their buying power.

If inflation is rising, Mortgage Bond investors must be compensated with a higher rate of return to combat the erosion of the Bond’s fixed payment, causing home loan rates to rise. As a result, inflation reports are followed closely, as they can have a big impact on Mortgage Bonds and the home loan rates tied to them.

Important Inflation Reports to Monitor

There are two main reports that measure inflation at the consumer level: the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), the latter of which is the Fed’s more favored measure of inflation. These reports have several important similarities, as well as some crucial differences.

Both CPI and PCE are each reported on a monthly basis and both reports will give us the data for the previous month (e.g., an inflation report that is released in February will give a reading of inflation for January). The CPI and PCE reports have two main components: Headline Inflation (overall inflation) and Core Inflation, which strips out volatile food and energy prices.

CPI measures prices on a fixed basket of goods and has a significant weighting towards housing and out of pocket medical expenses. PCE measures prices on a basket of goods but allows for substitutions. These substitutions will be for similar products. An example of this could be the substitution of honeydew melons for cantaloupe melons if the price of one were to rapidly increase due to supply issues. PCE tries to act like a smart shopper would.

Unlike CPI, PCE does not have a big weighting towards housing, which is obviously important, as well as out of pocket medical expenses. Instead, PCE focuses on Medicare and Medicaid expenses, which are kept by the government. As a result, PCE can underestimate the real inflation a consumer feels and it typically runs softer or cooler than CPI due to these factors.

Another important report to monitor is the Producer Price Index (PPI), which measures wholesale inflation. Like CPI and PCE, it has a Headline and a Core reading. Producer inflation does not always impact consumer inflation as producers may or may not pass on increased costs or decreased profit margins. The PPI may be a leading indicator of future consumer inflation. Although this is an important report, it usually “gets no respect” and rarely has an impact on the financial markets.

Why Inflation Is On The Rise

To understand why inflation has been rising, it’s important to understand how it is calculated.

Inflation is calculated on a rolling 12-month basis. This means that the total of the past 12 monthly inflation readings will give us the year over year rate of inflation. Each month, the most recent report replaces the oldest monthly reading. So for example, the CPI data that was reported today for January 2022, which showed that inflation rose  0.6% for the month, replaced the data from January 2021 (+0.2%) in the calculation of annual inflation. As a result, the year over year reading rose from 7% to 7.5%, pushing inflation to its highest level since 1982!

Part of the reason for the increase in annual inflation we have experienced is that readings throughout 2021 replaced the low inflation readings from 2020 when much of the economy was shut down due to the pandemic.

Again, rising inflation is significant because inflation erodes a Bond's fixed rate of return. In other words, rising inflation can cause Bonds to worsen or lose value. This includes Mortgage Bonds, to which home loan rates are inversely tied. When Mortgage Bonds move lower, be it due to rising inflation or other reasons, home loan rates move higher.

What to Look for From the Fed in the Months Ahead

The Fed has two levers they can pull for tightening the economy – hiking their benchmark Fed Funds Rate and reducing their balance sheet. The Fed Funds Rate is the interest rate for overnight borrowing for banks and it is not the same as mortgage rates.

Hiking the Fed Funds Rate will actually be a good thing for mortgage rates, as the Fed curbs inflation and preserves the fixed return a longer data Bond provides. However, reducing their balance sheet (which means allowing Bonds to fall off their balance sheet and no longer reinvesting in them each month) would cause more supply on the market that has to be absorbed. This can cause mortgage rates to move higher.

Last year, Fed Chair Jerome Powell saw inflation increase from 1.75% to 7%, and he let it increase because he thought this rise in inflation was transitory. This higher inflation caused mortgage rates to rise from 2.5% to around 3.5%, though this increase was moderated by the Fed’s ongoing monthly purchases of Mortgage-Backed Securities.

While the Fed is currently tapering these purchases, the Fed has vowed not to hike their Fed Funds Rate and reduce these purchases at the same time. If they end their purchases of MBS and Treasuries by March, as they are currently on pace to do, expectations are that they may also begin hiking the Fed Funds Rate at or before their March FOMC meeting.

The bottom lines is that Fed’s actions remain crucial to monitor in the months to come, as they will play an important role in the direction of the markets and mortgage rates this year.

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