Inflation Drives Interest Rates – Except When The Fed Gets Involved

As most people know, inflation drives interest rates because investors do not want to accept yields that are lower than the inflation rate because they will effectively be losing money if they do.

If you loan somebody $1,000 for one year at 5%, and inflation is at 8%, at the end of the year, you will effectively have lost 3% or $30 of purchasing power.

And fortunately for all of us, every bank that lends money for mortgages is willing to lose money because “real mortgage rates” (mortgage rate minus the rate of inflation) are clearly “negative” or below the rate of inflation (currently at 8.5%, per the CPI).

The MBS Highway pointed out today how closely mortgage rates track inflation – except when Quantitative Easing (QE) is in place, or when the Fed is buying mortgage-backed securities to keep rates artificially low.

Fascinating Chart!

I shamelessly stole the below chart from The MBS Highway video today, as it very clearly shows the inflation/interest rate correlation prior to COVID and QE, and the LACK of correlation during QE.

What the chart also clearly shows is how negative “real interest rates” are.

Takeaways:

1) Rates Will Fall: The MBS Highway pointed out that inflation is likely to drop for August when the report comes out next week, so rates will likely fall too now that the QE is over and the inflation/interest rate correlation is back to normal.

2) Negative Rates Are A Gift: We like to remind borrowers that negative rates are a gift, as banks are literally losing money on our behalf. That is why you see guys on Twitter screaming about how rates are effectively very low right now and how and why they are loading up on debt because of this.

3) Inflation Will Return With A Vengeance! While I think we will see a recession and a drop in rates sometime over the next 6 to 18 months, as per Jeff Snider’s and Barry Habib’s predictions, I think we will see inflation and much higher rates return with a vengeance after our next bout of low rates. This is because, among other things, we will likely face a fairly severe energy shortage that will drive prices way up (as per the latest MacroVoices Podcast), and because our government will have to monetize all of its debt by effectively printing money to pay it off.

ALL that inflation will: (1) drive home prices higher, as real estate is an inflation hedge like we saw in the 1970s, and (2) make today’s rates a gift.

My elderly neighbor was just telling me how he bought his house in the late 1970s when rates were 12%, and how he wished he had bought years earlier when they were only 8%…

I suspect we will be hearing a lot more of those laments in a few years.