Inflation and the Falling Dollar are Pushing Mortgage Interest Rates Higher

May 07, 2008

May 7, 2008 (Housing Market Monitor)

Housing Market Monitor

Inflation and the Falling Dollar are Pushing Mortgage Interest Rates Higher

May 7, 2008

By Dean Baker

"New Fannie Mae policy would allow homeowners who owe more than their house is worth to refinance to a lower interest mortgage."

The Washington Post reports that Fannie Mae is now allowing homeowners to refinance in instances in which they owe more than their house is worth.

The new policy is to allow people who already owe more than the value of their home to refinance into a lower interest mortgage. This is actually a very responsible policy, which it would be desirable to see other financial institutions adopt. It effectively means that Fannie Mae is taking some loss on the current loan in the hope that the homeowner will be able to meet the terms of a new loan.

There is nothing in recent news to suggest that housing is approaching a bottom or even that the rate of price decline is likely to slow. The record rates of foreclosure ensure that a substantial supply of homes continue to be brought to the market even at a time when inventory to sales ratios are already extraordinarily high. Builders also have an extraordinary backlog of unsold new homes (the supply is even larger than indicated in the Census data, since the data do not include homes where an initial sale was cancelled).

Tightening credit, coupled with a weakening economy and job loss, is constraining demand. Another factor that is likely to further constrict demand in the months ahead is higher interest rates. The 10-year treasury rate has been trending upwards, and the 30-year mortgage rate has moved with it. The Fed’s rate cut last week pushed up the 10-year rate by a few additional basis points.

It seems clear at this point that the Fed has little ability to lower long-term interest rates barring extraordinary measures (e.g. directly buying 10-year treasuries). With inflation rate hovering in the range of 3.0 percent to 4.0 percent, the real rate on the 10-year treasury bond is extraordinarily low at present. This low rate is especially striking since the dollar has been consistently declining in value for the last six years. It is likely that investors will increasingly switch their holdings to stronger currencies putting upward pressure on the 10-year treasury rate and the 30-year mortgage rate. While mortgage rates are unlikely to spike, even a modest drift upward to 6.5-7.0 percent would be very bad news for the housing market at present.

The other factor that will of course be depressing demand for housing is the weak labor market. The economy has been shedding jobs for four consecutive months and it is unlikely to turn around any time soon. The fact that this job loss has not been reflected in a sharp rise in unemployment is most likely attributable to the peculiarities of the household survey. Surveys clearly show that workers are increasingly pessimistic over their employment prospects, which does not provide a basis for a strong housing market.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. ( CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.

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