Why Low Inflation Is Good for You

Fifty years ago, economists didn’t think that inflation caused many economic problems. Then, in the late 1960s and throughout the 1970s, inflation rose to double-digit levels in the United States and many other countries. We learned that the costs of inflation may be significant and that a low inflation rate is ideal.

The problems caused by inflation can be divided into two parts: one based on the level of inflation itself (that is, an inflation rate of 8% is worse than an inflation rate of 2%) and another based on uncertainty about inflation (that is, a situation in which you don’t know if the inflation rate will be 3% or 5% is worse than a situation with a known inflation rate of 4%).

Problems Caused by Inflation

Inflation creates a number of problems for the economy: (1) shoe-leather costs; (2) menu costs; (3) imperfect taxation; and (4) a tilt in mortgage payments.

The first cost of inflation is what economists call shoe-leather costs, which is a euphemism for the costs that society incurs when people go to the bank frequently as they try to keep less cash in their pockets. When inflation occurs, your cash loses value because it earns no interest. If inflation is 10% and you keep $100 in your wallet, on average, you lose $10 each year in purchasing power. To minimize that cost, you might go to the bank more often and keep less cash in your wallet. The cost to individuals is fairly small, but for business firms that might have millions of dollars in cash outstanding, for example at retail stores, these costs can be quite high.

A second important cost of inflation is menu costs. These costs arise because inflation causes firms to have to change their prices frequently. The most obvious cost is for restaurants that may have fancy menus that are expensive to produce. Many other firms face this cost, especially firms that list their prices in large catalogues. Customers don’t like it when prices are constantly changing and firms cannot honor the prices they have printed in their catalogues. This problem is mitigated somewhat if the prices are only shown on the firm’s web site because those prices can be changed quickly, but the problem remains significant for many firms.

The third problem with inflation, which is even more significant, is that our tax system is distorted significantly by the presence of inflation. The higher the inflation rate is, the bigger the distortion is. The cost of a 6% inflation rate is more than twice the cost of a 3% inflation rate. The source of the problem is that the U.S. tax system is based entirely on dollar amounts. But the economic system is based on inflation-adjusted amounts. Those two systems clash strongly when inflation occurs.

Here is an example. Suppose you invest $10,000 in a stock that pays a 5% inflation-adjusted return each year and suppose you are in the 40% tax bracket (combining U.S., state, and local income taxes). If inflation is 0% and the inflation-adjusted return is 5%, then you earn a dollar return of 5% (note that the inflation-adjusted return plus the inflation rate equals the return in terms of dollars, so 5% + 0% = 5%). In dollars, you earn 5% × $10,000 = $500. Your tax will be 40% of the $500 return, which is 0.4 × $500 = $200. So, of the $500 that you earned, you get to keep $300 and the government keeps $200.

But what if the inflation rate is 10%? If you get the same inflation-adjusted return of 5%, the return on your investment is 15% in terms of dollars (5% inflation-adjusted return + 10% inflation = 15% return in dollar terms). In dollar terms, you earn 0.15 × $10,000 = $1,500. Now you are taxed 40% on your dollar return, so you will pay taxes of 0.4 × $1,500 = $600. You earn $900 after taxes and pay $600 in taxes. You might think that is fine, but now calculate how much the value of your stock has declined because of inflation. With a 10% inflation rate, your $10,000 worth of stock is now worth $1,000 less. So, in inflation-adjusted terms, your return is actually negative. In dollar terms, you got a $900 return but the value of your investment fell by $1,000, so your inflation-adjusted return is –$100, or –1%.

Why is your return negative? The main reason is that the government taxed you on the dollar amount of your return, rather than the inflation-adjusted amount of your return. One way to look at it is that of the 15% return in dollar terms that your stock generated, inflation got 10% of it, the government got 6% of it, and you got –1% of it; or in inflation-adjusted terms, the government gets 6% and you get –1% of the total inflation-adjusted return of 5%.

So, the higher inflation is, the more the government gets of your income and the less you get. That’s why sometimes governments create inflation to get out of budget problems—they get much more tax revenue and the inflation-adjusted value of their debt declines.

The fourth and final major problem related to inflation is that it distorts people’s mortgage payments. This is another fairly subtle problem that most people don’t realize is happening. The basic idea is that, the higher inflation is, the higher the mortgage interest rate is, and the inflation-adjusted value of your mortgage payment declines over time. This means that it costs you much more in inflation-adjusted terms to pay your mortgage early on and much less later. Here is an example.

Consider two situations, one in which inflation is 0% and one in which the inflation rate is 10%. In the low inflation case, suppose your mortgage interest rate is 4% but in the high inflation case it is 14%, so in both cases the mortgage interest rate equals 4% plus the inflation rate. How much would your monthly payment be on a $200,000 30-year mortgage? If inflation is 0%, your monthly payment would be $954.83. If inflation is 10%, your monthly payment would be $2369.74. Your monthly payment on your mortgage is much higher when inflation is 10% than if inflation is 0%. When you combine this with the fact that to qualify for a mortgage your monthly mortgage and total debt payments must not exceed a certain fraction of your income, you can see that when inflation is high, homebuyers will have to buy smaller homes to keep the monthly payments affordable. This problem is aggravated by the mortgage-tilt problem, which is illustrated in the next chart.

mortgage tilt

Chart: The Mortgage-Tilt Problem

Source: Author’s calculations

As the chart shows, when inflation is zero, the real (inflation-adjusted) value of the monthly mortgage payments is constant over time. But when inflation is high (10% in this case), the monthly payments are tilted; they are high early in the life of the mortgage and lower later in the life of the loan. This mortgage tilt creates a problem because you qualify for a loan based on the initial payment. So, when inflation is high, your mortgage is least affordable in the early years, and much more affordable in the past 10 years. But the result is that you may have to buy a smaller home when inflation is high because of the mortgage-tilt problem.

How to Adjust for Inflation

I was teaching a class in April 2013, and I started, as I usually do, by talking about the economic news of the past week and what it meant for the economy. A student said, “I thought the big news of the week was that the stock market had hit a new high level, surpassing the level it had been at before the financial crisis in 2008.” He was excited about that, as were many of the other students, most of whom worked on Wall Street. My reply was depressing to my students, but accurate, as I noted, “Although the news media trumpeted the new level of the stock market, they failed to account for inflation. Once you do that, you’ll see that the market still needs to rise another 7% or so before it is as high as it was in 2008 before the crisis.” I then proceeded to show them how to account for inflation properly, to see economic variables in real, not nominal terms.

The first chart shows a view of the stock market’s value in nominal terms (the dollar value of the market). You can see that in the past 15 years, the market reached local peaks in August 2000, October 2007, and August 2013. Before the financial crisis, in October 2007, the market (measured by the monthly average of the Standard & Poor’s 500 index of stock prices) stood at a level of 1539. As of August 2013, the index was 1670, which is 8% higher than it was in October 2007.

nominal stock prices

Chart: Stock Prices, in Dollar Terms

Source: S&P Dow Jones Indices LLC, S&P 500© [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SP500, May 1, 2017.

 

But remember that the dollar doesn’t buy what it used to buy. As we saw earlier, one dollar in 1965 buys the same amount of goods that $6 buys today. To get an accurate picture of the value of the stock market, we must adjust for inflation. The adjustment is not too complicated.  All you have to do is to divide the nominal (dollar) value of the stock market at each date by a measure of prices at that date. Doing so creates a real (inflation adjusted) index of the stock market, as shown in the next chart. To create the chart, I used the personal consumption expenditures price index as my index of inflation.

real stock prices

Chart: Stock Prices, in Real Terms

Source: Author’s calculations using data on S&P 500 Index and PCE price index (Bureau of Economic Analysis)

 

As you can see in this chart, adjusting for inflation matters a lot. You can see that the peaks in the market that we observed in nominal terms in 2007 and 2013 are well below the real level of the stock market in 2000. And, as of August 2013, the market was still 13% below its level in August 2000, in real terms.

The same idea can be applied in many other ways. Any nominal (dollar-denominated) variable can be adjusted for inflation to put it in real (inflation adjusted) terms. You might think your salary has been growing pretty well over time, but have you adjusted it for inflation? Over the past 16 years, nominal wages and salaries in the United States have gone up 2.7% per year, on average, but most of that rise was just to keep up with inflation. In real terms, wages and salaries have gone up only 0.9%, as inflation in consumer prices has averaged 1.8%. Similarly, we measure total U.S. output with GDP (gross domestic product). GDP has increased 3.8% in the past 16 years, but has increased only 1.8% in real terms (using a measure of inflation based on all prices of goods produced in the United States).

So, be sure to adjust for inflation whenever you are dealing with dollar figures, and don’t be fooled by inflation!

Inflation: The Impact of Food and Energy Prices

In the short run, oil prices have a major impact on inflation. But it is usually only a short-run effect and on only a few occasions has a spike in oil prices carried over into other prices since 1981. In a few years, a spike in food prices, rather than oil prices, has caused a jump in inflation. One way to see what inflation is doing while abstracting from oil prices and food prices is to calculate the inflation rate based on all goods and services except food and energy prices. This is shown as the dotted line in the chart, labeled “Core inflation”.

overall-versus-core-inflation

Chart: Inflation Rate, Consumer Prices

Source: Author’s calculations, based on Bureau of Economic Analysis data on personal consumption expenditures price index and the same index excluding food and energy prices (core inflation).

 

You can see immediately that core inflation is much smoother and less volatile than overall inflation. Core inflation is noticeably lower than overall inflation in the years of the oil-price shocks, such as 1974-1975, 1979-1980, and 2004-2005. In a few cases, oil prices declined and you see that core inflation is higher than overall inflation, such as in 1986. You can also see that much of the rise in overall inflation from 2004 to 2008 was driven by increases in food and (especially) energy prices. In a sense, the core inflation measure is the one to focus on because it gives us a better sense of overall inflation, abstracting from short-term shocks to food and energy prices. Although looking at the core inflation rate gets rid of short-term volatility and is thus more useful as an indicator for future inflation, the prices we pay for goods and services are measured by the overall inflation rate, so that’s the one that you want to look at to understand how much the dollar’s value has changed over long periods of time.

Because food and energy prices are so volatile, the policymakers at the Federal Reserve, who are in charge of keeping inflation low and stable, focus mainly on core inflation in setting policy. They know that if they were to respond to every shock up or down in the overall inflation rate, they would be changing interest rates far more often than is warranted. So, although they care about overall inflation in the long run, they know that in the short run their policy actions should be dependent on core inflation, not overall inflation.

Introduction to Inflation

Introduction to Inflation

The value of the dollar has declined dramatically over time thanks to inflation. Inflation is caused when the central bank (the Federal Reserve in the United States) allows the amount of money in circulation to grow too fast, or equivalently, if the central bank sets interest rates too low. Inflation causes the value of your money to decline, so you bear a direct cost. As we will see in my next series of blogs, inflation causes other problems in the economy that are severe, but are not felt directly by most people.

 

What Does a Dollar Buy Today?

When inflation occurs, prices of goods rise, on average. So, a dollar buys less than it used to buy. How much is a dollar worth today, compared to the past?

 

It takes this many dollars today          $2         $3      $4       $5       $6

To buy what $1 bought in this year    1985    1978   1974    1970    1965

 

As the table suggests, a dollar buys nowhere near what it used to. It now takes $6 to buy what $1 bought in 1965.

The data in the table are calculated by the federal government’s Bureau of Economic Analysis and come from a measure of prices called the Personal Consumption Expenditure price index, which shows the average price of goods and services purchased by consumers in the United States. This particular price index is superior to the more common Consumer Price Index, which is biased upwards and constructed in an inefficient manner. Compiling an accurate measure of prices is quite difficult because of changes in the quality of goods and the fact that people change their tastes for different types of goods. The Personal Consumption Expenditure price index that we use in this chapter has fewer problems than any of the various indexes that the government produces.

The price index shows how much the average price of goods and services has changed over time. To get an idea of how much prices have changed in a year, we can calculate the inflation rate as the percentage increase in the price index from one year earlier. The chart below shows the results of this calculation from 1960 to 2016.

inflation_pcepi

Chart: Inflation Rate, Consumer Prices

Source: Author’s calculations, based on Bureau of Economic Analysis data on personal consumption expenditures price index.

 

In the chart, you can see that inflation in the early 1960s was very low. But inflation began to rise steadily in the late 1960s and into the early 1970s. Then, from 1974 to 1975, inflation jumped to double-digit levels. Inflation dropped for a short time later in the 1970s, but jumped up again in 1979 and 1980. Inflation began to decline in the early 1980s, rose a bit in the late 1980s, and then declined to below 2 percent in the 1990s. The 2000s saw volatility in inflation, though on average inflation remained fairly low. The inflation rate was negative for a short time in 2009, mainly because of a sharp decline in prices during the financial crisis. More recently, the inflation rate has remained below 2 percent, which is sometimes thought to be the optimal rate of inflation (more on that in a future blog).

Adjustable-Rate Mortgages (Part 3)

In the two previous blogs on adjustable-rate mortgages, we discussed various indexes that are used to determine the interest rate on an adjustable-rate mortgage and we compared the interest rates on adjustable-rate mortgages to those on fixed-rate mortgages. In the last blog, we showed a chart that gave you an idea about how to compare the interest rates on the two types of mortgages over time. But it isn’t a very good chart to answer a key question: at any date, would I have been better off with a fixed-rate mortgage or a variable-rate mortgage? That is a more complicated question because it depends, in large part, on how long you plan to keep your house and how expensive it is to refinance your mortgage. Let’s think about two different scenarios and show you when you would have been better off with a fixed-rate mortgage versus a variable-rate mortgage. We’ll compare a fixed-rate mortgage of $100,000 at each date to a variable-rate mortgage in which your index is the one-year constant-maturity Treasury rate with a margin of 2.5 percentage points, with a 2 percentage point annual cap and a 5 percentage point lifetime cap, with a fixed initial teaser rate for 3 years that gives you a 1 percentage point lower initial rate. In scenario A, we’ll assume you keep your home for 10 years; whereas in scenario B, we’ll assume you keep your home for 20 years. If you save money on one mortgage versus the other, we assume that you will invest it in a one-year Treasury security, which has a similar yield to many other safe investment opportunities.

The results, shown in this new chart, are a bit of a surprise because they show that homeowners would have been better off with adjustable-rate mortgages rather than fixed-rate mortgages, if they had bought their houses any time after 1980.

net-profit-for-fixed-vs-adjustable-rate-mortgages

Chart: Net Profit from Adjustable-Rate Mortgage Over Fixed-Rate Mortgage

Source: Author’s calculations, based on Federal Reserve Board data on 1-year constant maturity Treasury interest rate; Federal Reserve Board data on fixed-rate mortgage rate

 

Here’s how to read the graph. The origination date (when the house was purchased) is shown on the horizontal axis. The vertical axis shows the net profit from having an adjustable-rate mortgage rather than a fixed-rate mortgage, adjusted for inflation, in thousands of dollars. We consider a family keeping a house for 10 years or 20 years. A positive net profit for a line on the graph shows that someone getting a mortgage at the date on the horizontal axis would have been better off with an adjustable-rate mortgage; a negative net profit means the person would have been better off with a fixed-rate mortgage.

You can see that the turning point is the period when inflation was at its highest, in about 1980. Anyone who got a mortgage before that date would have been better off with a fixed-rate mortgage. For example, a family that took out a mortgage loan in 1973, stayed in its house for 20 years, and had a fixed-rate mortgage, would have been $200,000 better off in 1993 than a similar family that had an adjustable-rate mortgage. But starting in 1980, which is the period in which the inflation rate peaks and then begins to decline, an adjustable-rate mortgage gives a net profit over a fixed-rate mortgage. For example, a family that took out a $100,000 mortgage in 1981, stayed in its house for 20 years, and had an adjustable-rate mortgage, would have been $280,000 better off in 2001 than a family that had a fixed-rate mortgage.

However, once we get into more recent periods, we see a pattern that is not surprising: adjustable-rate mortgages provide a small net profit over fixed-rate mortgages. This is not surprising because an adjustable-rate mortgage is riskier than a fixed-rate mortgage to the homeowner. The compensation for taking such a risk is the net profit. So, here is the bottom line: you can save money, on average, by getting an adjustable-rate mortgage, but it is riskier than having a fixed-rate mortgage. If the inflation rate increases after you get your mortgage, which is the main factor raising mortgage interest rates, then you will be better off with a fixed-rate mortgage. That’s the result we see in the chart for mortgages that were originated in the 1970s. But, if the inflation rate stays the same or decreases after you get your mortgage, then you will be better off with an adjustable-rate mortgage.

In recent years, the Federal Reserve has committed to keeping the inflation rate low and stable, as we will discuss in a later blog. If you believe that their commitment is credible, then you may want to get an adjustable-rate mortgage. But you must be aware of the risk that your monthly payment could rise. If your budget is tight, you will probably be better off with a fixed-rate mortgage to avoid that risk. And the net profit from having an adjustable-rate mortgage stayed pretty low for mortgages originated in the 1990s and early 2000s, so the cost of having a fixed-rate mortgage instead of an adjustable-rate mortgage is not great.

Refinancing

The analysis that we discussed above is not entirely foolproof because it did not consider the possibility of refinancing a mortgage. Had you taken out a fixed-rate mortgage in 1981, for example, you most likely would have refinanced it a few years later when interest rates declined. So, one additional consideration that we did not account for in the chart was the likelihood that someone would refinance. Thus, the net profits plotted in the chart are higher than would actually be the case. Still, the chart shows you the net profit if you never refinanced your mortgage. Of course, refinancing can be expensive, but should certainly be done if you have a fixed-rate mortgage at a high rate and you can lower your rate and your monthly payment.

Predicting Interest Rates

You might think that one way to choose between getting an adjustable-rate mortgage or a fixed-rate mortgage is just a matter of forecasting interest rates. In fact, if you could forecast interest rates better than other people, you could make a good choice. But remember that lenders are also forecasting interest rates. Unfortunately for both lenders and borrowers, interest rates are extremely difficult to forecast more than a year or two ahead, which is much too short a time to be of value in choosing a 30-year mortgage.

Adjustable-Rate Mortgages (Part 2)

In the previous blog on adjustable-rate mortgages, we discussed various indexes that are used to determine the interest rate on an adjustable-rate mortgage. But there is also a second piece of information that determines the interest rate on your loan: the margin. If you add the margin to the index rate, that is your mortgage interest rate. A typical margin is about 2.5 percent, though lenders may require a higher margin if your credit rating is poor. (Your credit rating depends on your past history of making payments on time on your loans, the size of your loan balances, your ability to pay, and so on. We’ll talk more about credit ratings in a future blog.)

Here is an example of how your interest rate is determined. Suppose your index rate is the one-year constant maturity rate, which is currently 0.5 percent. Suppose you have a margin of 2.5 percent. Then your mortgage interest rate is 0.5% + 2.5% = 3.0%. A typical adjustable-rate mortgage adjusts your interest rate once each year and your new monthly payment is based on that new rate.

There are some other factors to consider in choosing an adjustable-rate mortgage or a fixed-rate mortgage. First, many lenders will offer you a lower initial interest rate for a year or two on an adjustable-rate mortgage, which is sometimes called a “teaser” rate. Don’t be teased! For example, suppose your interest rate based on the formula in the preceding paragraph is 3.0 percent but your bank offers you a three-year teaser rate of 1.5 percent. Should you take it? The 1.5 percent rate for three years can save you a lot of money, but remember that you have another 27 years to pay. So, don’t be fooled by the initial low rate. You should figure out whether you can afford the loan based on the regular interest rate of 3.0 percent, as well as considering what might happen if the interest rate rises to an even higher level.

The second additional factor to consider is whether or not there are caps on the interest-rate adjustment. Although the basic formula for your interest rate each year is interest-rate = index rate + margin, sometimes interest rates rise (or fall) by 3 or 4 percentage points within a year. This can dramatically change your monthly mortgage payments. To reduce the risk of a very large change in the monthly mortgage payment that a homeowner might find difficult to handle, many loans have a built-in mechanism that: (1) keeps the interest rate from changing too much year to year and (2) keeps the interest rate from changing too much over the life of the loan. For example, a mortgage loan might have an annual cap of 2 percentage points and a lifetime cap of 5 percentage points. Then your rate would rise or fall at most by 2 percentage points each year and could never be more than 5 percentage points higher or lower than the initial interest rate.

Here is the difficult, but interesting part: at what times in the past would you have been better off with a fixed-rate mortgage as compared with an adjustable-rate mortgage? This is a very complicated calculation because each year the adjustable rate changes by an amount that is subject to the annual and lifetime caps. It’s also complicated by the fact that you could refinance your mortgage for a fee that usually amounts to one to two percentage points of the value of your mortgage. So, let’s just look first at a comparison of the interest-rate on a fixed-rate mortgage each month, compared with an adjustable-rate mortgage on the same date, where we will assume the adjustable rate is determined by the one-year Treasury constant maturity interest rate plus 2.5 percentage points. This will give you an idea of how variable the adjustable rate is compared with a fixed rate. The results are shown in the chart.

The chart shows you that adjustable rates and fixed rates move closely together. The adjustable rates change more from year to year. On average, the difference between the two is 0.4 percentage points—on average, adjustable rates are lower. That is logical because with an adjustable rate, you are bearing some of the risk of a change in market interest rates and the bank bears less risk; so, you are rewarded with a lower interest rate, on average. The other idea that you can get from the chart is that when interest rates are temporarily high, you are better off with an adjustable rate rather than a fixed rate because you will benefit when interest rates decline. When interest rates are temporarily low, you are better off with a fixed rate because you lock in the low rate.

 

arms-vs-frms

Chart: Comparing Fixed-Rate to Adjustable-Rate Mortgages

Source: Author’s calculations, adding 2.5% to Federal Reserve Board data on 1-year constant maturity Treasury interest rate; Federal Reserve Board data on fixed-rate mortgage rate

Adjustable-Rate Mortgages (Part 1)

An alternative to the standard fixed-rate mortgage is an adjustable-rate mortgage, also known as a variable-rate mortgage. With the standard fixed-rate mortgage, once you sign the mortgage agreement, your monthly payment is fixed for the life of the loan or until you sell the house or refinance it. An adjustable-rate mortgage is one in which your monthly payment can change over time.

Why would anyone ever want an adjustable-rate mortgage instead of a fixed-rate mortgage? There are two main reasons: (1) the mortgage interest rate might be high and you expect it to decline; and (2) on average, adjustable-rate mortgage interest rates are lower than fixed-rate mortgage interest rates. Since the early 1980s, the interest rate on fixed-rate mortgages has declined fairly steadily. As we will see, if you had bought a house in the early 1980s, you could have definitely profited by getting an adjustable-rate mortgage, which would have almost continuously adjusted downward. Generally, when the interest rate on fixed-rate mortgages is temporarily high, you may be better off with an adjustable-rate mortgage.

The way that adjustable-rate mortgages work is that they adjust your monthly payment every year (or sometimes every three years) depending on the movement of market interest rates. Many people don’t like that feature of adjustable-rate mortgages because they dislike the risk involved in not knowing what their mortgage payment will be. But if you can stand the risk, it can save you money. What you need to figure out is whether you can handle your monthly payment if interest rates go up and you have to pay more.

The interest rate on an adjustable-rate mortgage loan has two pieces: an index rate and a margin. Add the two and that is your interest rate. The index rate is an interest rate that moves with interest rates in the overall market. Examples include the one-year constant maturity Treasury index, the London Interbank Offered Rate (LIBOR), and the cost-of-funds index. Each represents a typical market interest rate. The one-year constant maturity Treasury index is a rate calculated by the Federal Reserve Board as the average interest rate on a Treasury bond with one year until it matures and the bond is paid off. LIBOR is the interest rate that banks in London pay each other for short-term loans in dollars; it is relevant for U.S. loans because there is a close tie between banks in the United States and in London, as they often enter into “swap” agreements to reduce their risk. A common index used for adjustable-rate mortgages is the 6-month LIBOR. The cost-of-funds index is the monthly weighted average cost of funds for savings institutions in the 11th district of the Federal Home Loan Bank.

The chart shows the movements of these rates over time. You can see that they all move fairly closely together, but there are some differences between them at various times. When interest rates in the overall market are declining, the cost-of-funds index is generally slower to decline than the other measures, as you can see in the mid-1980s, early 1990s, early 2000s, and from 2010 to 2013. When interest rates rise, the cost-of-funds index is usually slower to rise than the other indexes, as you can see in the early 1980s, 1994 to 1995, 1999 to 2000, and 2004 to 2006. The fact that the cost-of-funds index is slow to rise when other rates rise is good for borrowers in those times, but the fact that it is slow to fall when other rates fall is bad for borrowers in those times. On average, all the rates move together, so one particular rate is not better than the others. The one-year constant maturity Treasury rate and the 6-month LIBOR rate generally move closely together. A larger-than-normal discrepancy between them occurred in the financial crisis when LIBOR was set in an odd manner, which suggests that you might prefer to have the one-year constant maturity Treasury index or the cost-of-funds index for your adjustable-rate mortgage.

arm-indexes

Chart: Alternative Indexes for Adjustable-Rate Mortgages

Source: Federal Reserve Board data on 1-year constant maturity Treasury interest rate and LIBOR rate, Federal Home Loan Bank of San Francisco for COFI index

Refinancing Your Mortgage

In the 1950s and 1960s, mortgage interest rates didn’t change very much, so a typical homeowner bought a house, got a mortgage, and paid it off over 30 years. However, increased volatility of interest rates since the 1970s means that it is profitable to refinance your mortgage when the mortgage interest rate declines. Certainly, people who bought their homes in the 1980s when interest rates were above 10 percent should have refinanced their mortgage loans at some point. It only takes a small decline in the mortgage interest rate to make refinancing worthwhile. The difference in rates has to make a big enough difference in your monthly payments to make it worth the time, effort, and expense to refinance.

Almost everyone who took out a mortgage before 2009 could have profitably refinanced in 2011, 2012, or 2013. Mortgage interest rates dropped substantially from 2009 to 2013, so a homeowner is certain to pay less by getting a new mortgage than in sticking with the old mortgage. The cost of refinancing is generally about 1 percent of the total amount you are borrowing, but with a drop of 1 to 2 percentage points in the mortgage interest rate, refinancing will pay for itself within a year. So, why doesn’t everyone refinance? Part of the reason is that in the financial crisis, the value of many homes declined sharply, and banks will not refinance a mortgage loan for more than the home is worth. These days, banks are generally willing to only refinance your mortgage up to 80 percent of the home’s value, so the decline in home prices means that many homeowners will not be able to refinance their mortgages.

Given the ability of homeowners to refinance their mortgages, you can see why the percentage of the mortgage market that represents refinancing of existing mortgages (compared with financing new mortgages) rises as the mortgage interest rate declines. This relationship is shown in the chart. The blue dotted line shows that refinancing as a share of all mortgage loans is sometimes as low as 12 percent and as high as 72 percent. As the mortgage interest rate declined from 11 percent in 1990 to 3.5 percent in early 2013, the share of refinancing in the mortgage market generally increased. Whenever the mortgage interest rate rises appreciably, as it did in 1994, 1999, 2005, and mid-2013, you see that refinancing activity drops. And when the mortgage interest rate declines, many people refinance their homes and the market share of refinancing rises.

refinancing

Chart: Share of Refinancing in Mortgage Market

Source: Federal Reserve Board data on 30-year conventional mortgage interest rate, Mortgage Bankers Association share of refinancing

The Inflation-Adjusted Mortgage Interest Rate

In the previous blog, I showed you data on mortgage interest rates. But inflation has distorted some of the movements of these interest rates over time. You see much higher interest rates in the late 1970s and early 1980s than in other periods, which was caused by the higher inflation in that period. If we adjust for the difference in inflation by subtracting from the interest rate a measure of expected inflation, then we get a more accurate view of the cost of borrowing for a home, as the chart here shows.

Inflation-adjusted mortgage interest rate

Chart: Inflation-Adjusted Mortgage Interest Rate

Source: Federal Reserve Board data on 30-year conventional mortgage interest rate, adjusted by author for expected inflation using forecasts of inflation from Survey of Professional Forecasters, Federal Reserve Bank of Philadelphia

 

After adjusting for inflation, we can see that the mortgage interest rate is very low by historical standards today. After a lot of volatility in the mortgage interest rate in the 1980s, it settled down and averaged about 5 percent in the 1990s, then declined to a range of 3 to 4 percent in the early 2000s. After the financial crisis in 2008, the mortgage interest rate dropped dramatically to under 2 percent in 2011, reaching its all-time low at the end of 2012 of 1.1 percent. Most recently (as of the first quarter of 2016), the rate is 1.6 percent, still extremely low.

By adjusting the mortgage interest rate for expected inflation, we arrive at a measure that economists call the “real” interest rate, which is a more appropriate measure than the usual “nominal” interest rate. The nominal interest rate tells you how many dollars you have to pay to cover the interest on your mortgage loan. The real interest rate tells you, more appropriately, the amount of goods and services you need to forgo to cover the interest on your mortgage loan. For example, in the first quarter of 2016, the nominal interest rate was 3.7 percent, the long-term expected inflation rate was 2.1 percent, so the real interest rate was 3.7% – 2.1% = 1.6 percent. You expect to have to pay 3.7 percent more in dollar terms each year to cover the interest on your mortgage, but those dollars are expected to be worth 2.1 percent less each year, so the true cost in terms of goods and services you forgo to pay the interest on your loan is 1.6 percent each year.

Mortgage Interest Rates

The mortgage market is just one of many markets competing for funds in the overall marketplace for credit. As such, funds tend to flow across markets in response to increased demand. Interest rates in all markets are thus correlated, with differences depending on factors such as the risk to any particular sector of the economy. It turns out that the interest rate on mortgages is linked fairly closely to the interest rate on ten-year government bonds. The interest rate on 30-year mortgages averages about 1.7 percentage points above the interest rate on 10-year U.S. Treasury bonds, as Chart 4 shows. During the financial crisis, the difference between the two interest rates increased quite a bit because of the perceived risk to mortgage loans, ranging between 2 and 3 percentage points from November 2007 to March 2009, but has declined since. In May 2016, the interest rate on mortgages was about 3.6 percent, while the interest rate on 10-year government bonds was about 1.8 percent, so the 1.8 percentage point difference between the two was not much above the historical average of 1.7 percentage points.

Mortgage interest rates 2016 June

Chart: Mortgage and Ten-Year Government Bond Interest Rates

Source: Federal Reserve Board data on interest rates