Inflation Fears

Long-Term Rates Jump

The most significant recent development affecting real estate is a fairly sudden surge in long-term interest rates. In just the last three weeks, the cost of a 30-year, fixed rate mortgage has climbed from around 5.8% to almost 6.5% -- in lenders' parlance, a rise of 70 basis points.

This change is quite clearly a reaction to accelerating inflation -- actual and expectations. As the cost of energy, food, and other items climb, long-term lenders understandably need a higher return to preserve their capital (let alone earn a profit). Also adding pressure: Federal Reserve Chairman Ben Bernanke signaling that fighting inflation is becoming a higher priority than combating economic weakness through continued monetary easing and low interest rates.

Note: although the Fed effectively sets short-term interest rates, and the Treasury decides how much money to print, the financial markets determine long-term rates.

In the long-run, higher interest rates are an (almost**) unqualified negative for the housing market. Most of the money used to buy most homes is borrowed, and more expensive money erodes buyers' purchasing power (See next post, "Monetary Policy for Dummies").

Conservatively assuming that buyers put down 20% and borrow the rest, a 12% rise in interest rates effectively translates into a 10% rise in the cost of housing. As Econ 101 teaches, when prices go up . . demand goes down.

Short-Term Catalyst?

In the short-run, however, increasing rates may actually stimulate the housing market and sales activity. As any realtor active this Spring knows, this market is full of nervous, hesitant buyers who've been reluctant to pull the trigger. Now, the prospect of further rate jumps will no doubt spur some of those buyers to lock in historically cheap money while they still can.

**In the really long run, one could make a case that higher interest rates are actually a positive for the economy, if not the housing market. As painful as Paul Volcker's early '80's rate hikes were, they succeeded in wringing then-rampant inflation out of the economy. In turn, that set the stage for the best 20 years the U.S. economy has ever had.

Of course, as (famed economist John Maynard) Keynes noted, "in the really long run . . we're all dead."