Friday, December 14, 2007

U.S. Inflation Numbers and the Mortgage Market.

The article, “Consumer Price Up 0.8% in November,” was published in the New York Times online on December 14, 2007.

Quotes from the article:

  1. “The worry is that the jump in energy costs will leave consumers with less money to spend on other items, worsening the slowdown in economic growth that is already happening.”
  2. “The 0.8 percent rise in consumer prices was worse than the 0.6 percent advance that economists had expected. With one month to go, inflation in 2007 is rising at an annual rate of 4.2 percent, far above the 2.5 percent increase in 2006.”

My opinion:

  1. Economic theory tells us that this is not a problem with inflation.
  2. This may be a positive sign for those of us with a fixed rate in the mortgage market.

Economic theory clearly states that falling purchasing power - rising prices reduces the number of goods and services bought by a typical consumer – is not a cost of inflation. Why? Many other monetary variables, such as salaries and wages, are tied to inflation. If prices rise by 4.2%, then the average salary also rises by 4.2%; there is no change in the number of goods and services bought by the consumer. The only reduction in purchasing power associated with the jump in energy prices is short-lived; there is a time during which the other monetary variables, such as salaries and wages, adjust.

Negative economic growth (which hasn't happened yet) and rising inflation are two separate entities with different economic costs. Falling growth will result in a loss of jobs; rising unemployment is one cost of falling income. Rising inflation results in several economic costs – one being a redistribution of wealth from the loan entity (bank) to the borrower (agent that takes out the loan).

Those of us who locked in a mortgage rate stand to gain from the higher than expected inflation rate! Banks make decisions about mortgage interest rates based on current and expected market conditions. If banks expect a rate of inflation of 3% (for example), then the interest rate must be at least 3% to tie the loan with inflation (keep the value of the loan payments the same).

Wages are indexed annually for inflation, while the many mortgage rates are fixed at a predetermined interest rate. If inflation is higher than expected (4.2%, for example), then it is easier for the borrower to pay back the loan. This is the redistribution of wealth from the loaner to the borrower. Borrowers with fixed mortgage rates actually welcome higher inflation!

There are welfare considerations of higher inflation on the mortgage market. Holding constant the negative effects of any reduction in economic growth, those consumers with fixed rates benefit from higher-than-expected inflation rates. On the other hand, those consumers with variable rates, at the very minimum, are not hurt since wages rise with the inflation rate. This will create a growing disparity between the wealth of consumers in the mortgage market. The fixed rate consumers become less and less indebted, while the variable rate consumers become perhaps more and more indebted. This is a real economic cost, as bankruptcy and foreclosure rates start to rise.

Ben Bernanke gives a speech regarding inflation expectations and inflation forecasting at the Federal Reserve Bank. The Fed can predict well prices for individual goods for up to two quarters, but uses larger macroeconomic models to predict longer timespans. Overall, he argues that the forecasts (which are not revealed to us) have been rather successful. Forecasting, however, is a difficult science, and subject to unforeseen events. Let’s assume that the Fed has the expected inflation forecast in check, and that the inflation numbers are not as bad as the New York Times would have you believe.

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