Why are mortgage rates so high?

Over the past few months in 2022, many home buyers have been surprised at the speed at which mortgage rates have increased to levels we haven't seen since 2009.  Below is an example of the past 12 month history of the average 30 year fixed mortgage rate offering.

1. May 2021 - 3.12%
2. June 2021 - 3.17%
3. July 2021 - 2.86%
4. August 2021 - 2.91%
5. September 2021 - 3.15%
6. October 2021 - 3.22%
7. November 2021 - 3.24%
8. December 2021 - 3.24 %
9. January 2022 - 3.68%
10. February 2022 - 4.18%
11. March 2022 - 4.78%
12. April 2022 - 5.41%

So why the heck are mortgage rates so high?  

In one word, inflation.

While there are dozens of inflationary reports out there, for purposes of this article we're going to discuss three.  The producer price index (PPI), the Consumer Price Index (CPI), and the PCE (Personal Consumptions Expenditures) are the big inflation reports that everyone should be monitoring closely right now.

First, let's tackle the main principle behind why inflation hurts mortgage rates.  The best way to illustrate the point, is to have you pretend that you are a mortgage lender.  If you were going to lend a borrower $200,000 to buy a house, and that borrower paid you $1,000/mo to service the loan, then you (the lender) are receiving $1,000/mo in payment.

Now let's say this is your only source of income, and you want to buy every day living expenses like gas and groceries.  Let's assume that your monthly budget is $1,000/mo for these expenses.  Right now, you're sitting pretty because you can afford to pay your monthly gas & grocery budget.

Enter inflation.

According to the CPI report from the US Bureau of Labor Statistics, food costs have risen 8.8% year over year, and fuel costs have risen a whopping 32% year over year!  

With inflation pushing the cost of everything up, you can no longer afford to pay your monthly gas & grocery budget, and therefore, you have to charge a higher interest rate to new clients to keep pace with inflation so that you (the lender) can pay your bills.

According to the graph above, the average cost of "All items" has risen 8.50% year over year.  If you're a bank, how can you keep lending money out at 5.50%?  Banks are losing about 3% on their money by lending it out once you factor in the cost of inflation.  As a borrower, you're actually earning 3% on that money because you're able to borrow the money for less than what items are increasing in cost.  Even though mortgage rates have risen recently, technically, they are negative once you factor in inflation.

If inflation continues at 8.5% year over year, might this give you an idea of where mortgage rates could be headed if the Federal Reserve aka "The Fed" can't get inflation under control.

There's just one problem.  The Fed doesn't look at food and energy costs when deciding monetary policy.  Rather than the CPI report, the Fed uses the PCE report (which strips out food & energy costs).  Right now, the  PCE is hovering around 6.5%.

If you've looked at the graph above, you might notice a small problem with that metric.  Remember that energy costs have risen 32% year over year!?

So why doesn't the Fed look at fuel & energy costs when deciding monetary policy?  

To answer this question, it's important to understand how the Fed fights inflation.  One of the main ways the Fed fights inflation is to raise the target federal funds rate.  When the fed raises the federal funds rate, the cost of money that they charge to banks increases.  As a result, banks increase their interest rates to maintain their profit margins, and the cost to the consumer ultimately goes up for lending.  As loans become more expensive, people borrow less and spend less.  Less lending = less money in circulation, and less money in circulation results in an eventual slow down of the economy (aka recession) because access to credit keeps the economy moving.

You can't tell me that food & energy costs will come down if the Fed hikes the federal funds rate.  Those things are not connected in any way shape or form.  The reason the Fed doesn't factor in food & energy costs into the equation is because the Fed doesn't have any control over food and energy costs!  

Controlling food & energy prices are determined by foreign & economic policy, not monetary policy.  Quick example - the war between Russia & Ukraine has created sanctions against Russia, meaning the US (amongst other countries) are no longer buying Russia's oil.  As a result, there is a lack of supply for oil, and just like in housing, lack of supply combined with stable/increasing demand causes prices to rise.  The Fed has nothing to do with the war against Russia and Ukraine, that is strictly up to the presidential office to decide how to handle that situation, but rising food & energy costs do impact the consumer.  As food & energy costs rise, consumers will shift the way they spend money and likely stop spending money on non-essential items.  Less spending on non-essential items could actually cause the PCE numbers to fall, because less demand for non-essential items creates lower prices in those categories.  At the same time, rising fuel costs do make their way into the every day goods and services we buy (like groceries, clothing, furniture, junk on Amazon), so eventually food & energy slowly finds it's way into the PCE report by default.

Does the Fed care about mortgage rates?

Nope.  The Fed has a dual mandate, which is to keep inflation at around 2% and to keep the unemployment rate low.  That's it!  Nowhere does it say the Fed should keep mortgage rates low.

Unfortunately, the problems we're experiencing with high inflation are related to rising food & energy costs, which the Fed doesn't monitor or control.  If the PCE report hits 2%, the Fed will have achieved it's goal and will stop raising rates.  Meanwhile, food & energy costs on the CPI report can continue at 8% or higher, and every day citizens will continue to feel the effects of high inflation.

Mortgage rates won't come back down until food & energy costs subside, which likely won't happen until the Russia/Ukraine situation gets sorted out, or until we start producing more of these goods within the US.  I forgot to mention that Ukraine is the "bread basket" of the world, and with the war, much of their exports are no longer feeding the rest of the world.  Less supply of food means prices for food go up and/or food shortages, starvation, etc.

Rising mortgage rates should be the least of our concerns right now, but there is still room for mortgage rates to rise further.  At least until the inflation beast is tamed.