What Inflation Near 5 Means for Mortgage Rates

A new inflation forecast from the White House may signal an upcoming rise in mortgage rates.

The latest forecast from the Office of Management and Budget (OMB) predicts a 4.8% rise in consumer prices from last year for the fourth quarter of 2021. That’s more than double the 2% annual inflation rate projected in May.

It’s widely believed that near the 5% inflation will be short-lived as supply chains recover from pandemic-related disruptions. However, inflation is closely tied to mortgage rates, and will likely affect them in the coming months.

How inflation impacts mortgage rates

Inflation occurs when the U.S. dollar buys less goods and services. Although it shows up on price tags at the grocery store, it doesn’t necessarily mean that milk became more valuable or expensive. Rather, the money you’re using to buy milk became less valuable.

This concept also applies to things that are valued in U.S. dollars, like mortgage-backed bonds. When inflation rises, the value of mortgage-backed bonds decreases. This causes these bonds to become a less attractive investment.*

Interest rates have to rise to keep investors buying. Higher rates on mortgage bonds translate to higher consumer mortgage rates.

Why do rates of return, or yield, have to climb during times of high inflation?

Let’s assume a mortgage bond pays an investor 3% per year. But inflation clocks in at 4%. The investor loses 1% of their money each year simply because inflation outpaces the interest on the investment.

That mortgage bond would have to pay 5% per year for the investor to yield a true 1% return. So, are rates going that high?

Related: Will the Housing Market Crash in 2022?

Will fourth quarter inflation raise interest rates?

It’s well-established that inflation leads to higher mortgage rates. The question about the current high inflation environment would be how long it will have a chance to impact mortgage rates.

The 4.8% inflation figure for the fourth quarter is a steep rise from the 2% prediction from May. However, OMB also predicted that this figure would come down to 2.5% by the fourth quarter of next year. If that forecast is true, high inflation won’t be long-lived, and will have limited time to affect mortgage rates.

The greater threat to low interest rates is the Federal Reserve’s imminent decision to taper its mortgage-backed security (MBS) purchase. During the pandemic, the Fed has been keeping mortgage rates artificially low by increasing its MBS purchases. However, it has already signaled that it may begin to reduce its purchases by November.

Even an announcement of a purchase tapering plan could cause mortgage rates to jump, and many think the Fed will announce a plan during its upcoming September 21-22 meeting.

Whether it’s inflation, the Fed Taper, or a combination of both, mortgage rates likely to rise by the end of the year. For some homebuyers, that may not be a big deal. Rates are rising from an exceptionally low place, after all.

But for those determined to lock in a sub-3% rate to buy or refinance a home, time may be running out.

Some references sourced within this article have not been prepared by Fairway and are distributed for educational purposes only. The information is not guaranteed to be accurate and may not entirely represent the opinions of Fairway.

*The information in this article does not constitute financial planning advice. Please consult a financial planner regarding your specific situation.