Tuesday, August 12, 2008

Mortgage rates set to rise with inflation, Fannie Mae and Freddie Mac troubles

Recently, growth and stable prices have come under siege, and the Fed has performed a very precarious balancing act with the economy; growth has remained resilient and inflation mostly contained. Fannie Mae’s and Freddie Mac’s recent stress have pushed up interest rates further, and with already rising mortgages rates, the economy is certainly walking a tightrope.

The chart above shows three things. First, 30-year mortgage rates remain at record lows. In fact, since 1971, the current rate, 6.4% in July, is 12% lower than the 1981 high, 18.5%. Second, inflation and interest rates tend to move together. Inflation is on the move, and if left unchecked, will eventually bring mortgage rates with it. Third, mortgage rates have been rising since May 2008, roughly coinciding with Fannie Mae and Freddie Mac problems.

Inflation expectations affect interest rates, and have recently pushed up mortgage rates. Interest rates are set according to expectations over future inflation. If inflation expectations continue to rise (let’s say banks believe that inflation sit at 8% next year), then banks will raise interest rates. Saving rates, car loan rates, mortgage rates, CD rates, and all nominal interest rates, are set according to expected inflation and subject to upward pressure.

Banking sector stress affects interest rates, and recent troubles with Fannie Mae and Freddie Mac have pushed up mortgage rates. Congress passed a reforming housing bill that included provisions for Fannie Mae and Freddie Mac that seemed to calm the markets for a month, but another shoe is dropping. The S&P cut some of Fannie Mae and Freddie Mac’s debt ratings, and the firms may be forced to call on the U.S. Treasury for capital.

Two things are happening to put pressure on mortgage rates:

1. Inflation expectations are rising → mortgage rates rise → economic growth falls
2. Fannie Mae and Freddie Mac → mortgage rates rise → economic growth falls

Mortgage rates are rising with the banking sector’s fear of Fannie and Freddie failure; if this continues, the Fed may be forced to target lower interest rates. However, it is not clear that this would have any affect on actual mortgage rates until Fannie and Freddie sort out their balance sheets.

Please leave comments. Best, Nontruths


  1. What happens if demand for mortgages falls?

  2. Theoretically, higher interest rates lower investment (machines and capital, nonresidential investment, and residential housing). If the negative effect on demand for mortgages coming from higher rates is less than the positive effect coming from falling home prices, then fewer people will take out mortgages; this will reduce the number of potential homebuyers on the market. The demand for housing will continue to slide, and bring with it, home prices. Eventually, home values will slide so much as to entice new customers no matter what the mortgage rate.

    One key feature of a brighter economic outlook is the stabilization of the housing market - if mortgage rates continue to rise, the stabilization may be pushed back by several months (or even quarters, years).

  3. What are the macro-effects of rising nominal interest rates and low stable inflation on the housing market?

  4. what the fffffffffffuuuuuuuuuuunnnnnnnnnnnkkkkkkkkkk


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