You may have noticed interest rates increasing over the last few weeks, but why does this happen? The main answer has to do with inflation. Inflation occurs when prices rise, decreasing the purchasing power of your dollars. For example, if your dollar can buy you five apples today, but only one apple tomorrow, your buying power weakened and your dollar doesn’t go as far.
Why does raising inflation impact interest rates negatively? Essentially, investors’ appetite for bonds decreases because inflation erodes the return on their investment, which causes bond pricing to drop since there is lower purchasing demand. As bond pricing decreases, long term interest rates increase.
Two economic reports that measure inflation are the Consumer Price index (CPI) and the Personal Consumption Expenditures (PCE) report. The recent CPI report was released on March 10th showing that inflation increased by 0.4% in the month of February. The year over year reading showed inflation increased from 1.4% to 1.7%.
The last PCE report came out on February 26th showing that inflation ticked up by 0.3% for the month of January. This index increased from 1.3% to 1.5% compared to last year. The PCE is the Federal Reserve’s favored gauge of inflation, and they have a mandate to attempt to throttle it at around 2.0%.
Going forward, it appears that inflation will continue to rise. The inflation numbers that were released this time last year were very low, and in some months actually negative. For example, the CPI for April was -0.4 and -0.1 for May. This means we are seeing inflation at much higher levels nearing 2%, if not getting closer to 3% on the year over year numbers. To summarize, as inflation spikes it will put fear in bond investors which will cause bond pricing to fall and yields to rise, causing mortgage rates to increase.