One of the ways that a stronger economy can impact rates is through inflation. Remember, at the end of 2010 the Fed initiated its second round of Quantitative Easing (QE2), with one of their stated goals being to avoid deflation, and actually create inflation.
This is an important topic to keep an eye on in the coming year and keep your clients and referral partners educated about, since inflation is the archenemy of home loan rates.
Why? Because home loan rates are tied to Mortgage Backed Securities, which are a type of Bond. So as Bond prices improve, so do home loan rates. But when inflation – or even just fear of inflation – grows, Bond prices fall. That’s because lower Bond prices are needed to give Bond investors juicier yields that will help outpace inflation.
Here’s an analogy that you can use to help explain this relationship to clients and referral partners. Think of inflation as the ocean and interest rates as a boat. As inflation (or the ocean’s tide) rises, interest rates (or the boat floating atop the ocean) have to rise as well. In other words, interest rates (or boats) must always be higher than inflation (or the ocean) in order to compensate investors.
Right now, the headline numbers in the US show little inflation overall…but we already saw significant inflation in particular items like commodities, food, and oil – which were driven by a weak US Dollar and increasing demand from emerging countries like China and India.
But with the Fed’s QE2 and the stimulative measures introduced to help strengthen the economy, we could be looking at a 1.5% increase in consumer inflation by the end of 2011 – still within the Fed’s comfort zone of 1 – 2%. So inflation should not be a threat this year, however, the unprecedented amount of debt accumulation on the part of the US could spark significant inflation down the road. It’s easy to see why Bob Weidemer feels that “the medicine the government has been using to boost the economy (QE2)…will eventually become the poison.”