Update on Inflation and Interest Rate

Looks like interest rates are going to go up – at least temporarily! With Mr. Greenspan and Co on the Senate floor talking about the fear of inflation etc. etc. I am sure things are going to get a bit rough in the coming months.

Why do you say is inflation such a big deal? How is this connected to mortgage rates? Well, let me explain. Inflation is one of those things that is actually a sign of good times. When more and more people have jobs, and more and more good things are happening in the economy, then prices tend to rise. Inflation is nothing more than a measure of prices.

In fact the Fed uses what is called the Consumer Price Index to keep track of prices. The CPI is a measure of prices of a set of goods and services used by the “average” American family. By tracking the prices of the basic necessities and consumed goods, the CPI gives an indication of what happening. The base year for the CPI is 1984 – meaning all the increases are measured against that year. So, if you hear that the CPI is 134, it means that today’s prices are 34% above that of 1984.

The CPI has been showing upward movement lately. This is not good. When inflation goes up it affects the value of long-term bonds. In fact the price of long-term bonds goes down, when this happens the yields tend to go up to make up for the lost bond value. So, with inflation showing upward movement, the interest rate charged on bonds such as the 10-year treasury and mortgage-backed securities goes up. And when this happens mortgage rates tend to go up.

I think this rise is going to be short term – less than 3 months. Why? Well, the CPI is going up because of the good Christmas season. Since there is a time lag between the even and the analysis – the CPI we hear of today is actually from factors in late 2004 (the Christmas/New Years season). Once this glut settles down, the CPI should settle down as well.

So, while those in the market for real estate today are affected, I don’t believe the buying and selling of the summer season will be adversely affected. In fact with interest rates holding steady, and incomes rising a bit, I bet the summer of 2005 will be a great year for buying and selling homes!

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