Will “slack” offset inflationary pressure of money supply?

This article appeared in the WSJ over the weekend.  It examines the impact that “slack” in the economy is having on curbing the inflationary pressures of money supply.

A couple weeks ago I posted this piece in which I wrote about Irving Fisher’s equation of exchange.  When you solve for price level (a change in which is the definition of inflation) you arrive at P=MV/Q where M= money supply, V=velocity of money, and Q= GDP.

In effect the WSJ article is arguing that although M has increased over the past year with government stimulus efforts V has slowed drastically and is expected to remain low for some time.  In essence, V represents “slack” in the economy.

At some point the economy will begin to rebound and the Fed will need to figure out how to unwind the money supply or else we may see double digit inflation which would likely lead to double digit mortgage rates.

Will bailout lead to weaker US Dollar?

Vitaliy Katsenelson wrote a good article for Forbes today about the impact that a $700 billion bailout would have on confidence in the US dollar.


In the past, we did not really have to worry about the financial strength of the U.S. government. Today, that financial strength has been tested. I doubt it will happen but I would not be surprised if Microsoft’s new AAA-rated bonds will have a lower yield than US Treasuries.

In other words, if the US government commits to a $700 billion bailout plan investors know that they will have to effectively print money to foot the bill.  Increasing the money supply would lead to higher inflation and therefore higher interest rates.

Although unlikely could you imagine if US debt carried higher rates of interest than AAA corporate debt?

However, he goes on to mention:

On the bright side, the bailout may or may not end up being a bailout. If the government were to buy loans for 30 cents on the dollar that are worth at least 30 cents, then the government is providing liquidity–the cost to taxpayers is zero. Not necessarily a bailout.

Hopefully the latter is the case.

Kudos to Barron’s part II

After reading and blogging about one article in Barron’s this weekend I came to another outstading one.  Here is a link.  Nice work Barron’s.

Among the points that I found interesting:

* If Fannie Mae [ticker: FNM] and Freddie Mac [FRE] stopped all of their activity — for a moment, forget about shutting them down and being insolvent — in order to sell off mortgages as normal loans without this guarantee, the interest rate would have to be around 9% or 10%.

* Q: What other negatives do you see?

A: Inflation risk down the line. [The federal government is] going to probably overstimulate and over support in an attempt to stem these deflationary forces. We are looking at a longer-term inflationary force that is pretty substantial. This has been my view for a long time. Interest rates went into a very long decline from the late ’70s and early ’80s until earlier this decade, when first we saw rates bottom out. Then rates went up a couple of times.

Basically, we are getting back down toward those low levels again. The multiyear bottom in interest rates that started around 2002 will probably last into 2009. Then we are going to see the inflationary aftermath of these government policies, and you might be surprised at how high interest rates go.

* Q: How much more pain are we going to feel in the housing market before things start to stabilize?

A: I think we are about half way through. There is high momentum in terms of home-price declines, so it is pretty clear they are going lower. It always looks a lot like the hills on a roller coaster. It starts out with a flattish period. Then it starts to go down, and then it really starts to drop, and we are clearly in that period. That period is going to be with us for about another year before it flattens out and bumps along in 2010.

The S&P/Case-Shiller Index is down a little more than 15% from its peak in 2006, and I’ve believed for some time that the index will have dropped 30% from its peak. That means some markets are going to drop by 50%. That includes Miami, Las Vegas and Phoenix, all of which were fueled by subprime lending. The foreclosure overhang is so big in those areas.

Gas prices expected to rise thanks to Ike

According to this article on CNN Money’s website gas prices are expected to climb back towards the $4/ gallon level.  Althugh there is still a lot of uncertainty about the extent of the damage to oil producing infastructure caused by Hurrican Ike it looks like gas prices will be increasing.  I’ll be filling up my tank today!

Keep in mind that higher energy prices can add inflationary pressure on the economy which is bad fro mortgage rates.

Phil Fisher on causes of inflation

In 1958 Phil Fisher wrote an investment classic called, “Common Stocks and Uncommon Profits”.  In the first chapter he wrote a very profound statement regarding the cause of inflation.  This seems to be extremely applicable in today’s economic environment:

It seems to me that if this whole inflation mechanism is studied carefully it becomes clear that major inflationary spurts arise out of wholesale expansions of credit, which in turn result from large government deficits greatly enlarging the monetary base of the credit system.”- Phil Fisher

Bernanke’s outlook & mortgage rates

In his speech to the worlds most powerful central bankers today Fed Chairman Ben Bernanke spoke briefly about inflation according to this NY Times article

From the article, “Mr. Bernanke, while acknowledging ‘an increase in inflationary pressure,’ reasserted his view that in the near future, the upswing in inflation from the oil and food shocks was likely to moderate.”

If his outlook proves correct this would be a good sign for mortgage rates.  Mortgage rates have ticked higher over the past few months in response to higher inflationary pressures (i.e. commodity &/ energy prices).  If these pressures to moderate then hopefully mortgage rates will also move lower.


Rate Update for August 20, 2008

Rates are modestly lower this morning.

Renewed credit worries have helped mortgage rates remain low in the face of hot inflation data.  Here are links to the articles that were referenced in today’s rate update video:

Blog posting & link to Sunday’s Barron’s article regarding the inevitable nationalization of Fannie Mae and Freddie Mac (this article had kicked off renewed credit worries and likely caused the 20% drop in Fannie Mae and Freddie Mac stock prices on Monday).

Associated Press article about “liar loans” (appeared in Oregonian yesterday as well as yahoo.com and other news sites).

Blog posting regarding tax holdbacks (please feel free to write a comment on my blog and/ or pass along to others who would benefit from this information).

Current Outlook: neutral with floating bias

Rate Update for August 19,2008

Rates are unchanged again this morning.

Last Thursday the Labor Department issued the monthly Consumer Price Index (CPI) report which showed that prices at the consumer level in our economy grew at the fastest pace in 17 years. 

Today, the Labor Department released the monthly Producer Price Index (PPI) report which reports on prices at the wholesale/ manufacturing level of our economy.  The report indicated that prices increased by 1.2% in the month of July alone & 9.8% on a year-over year basis!  This marks the fastest growth in wholesale prices in over 20 years! 

This double shot of hit inflation news ordinarily would be terrible for mortgage rates but they have yet to move higher.  Why?

It may be because traders believe that much of the cause for the rapid increase in prices can be credited to higher oil prices in July.  Since oil prices have declined in August they may believe that the increases in July are temporary. 

Furthermore, stocks are not taking the inflation data well so we are also seeing a “flight to quality” in the financial markets.

Current Outlook: neutral

Inflation pressures

If you’ve been a consistent reader of ‘rate update’ or this blog you know that inflation expectations are the primary factor for driving mortgage rates. When expectations of inflation increase it causes rates to rise and vice versa.

There are two articles published this morning which give contradictory forecasts for inflation. It just goes to show that no one knows for sure. Here are links to read for yourself:

Barron’s: Inflationary Risks Increasing

WSJ.com: Fed’s Kohn Sounds Upbeat Note, Says Current Rates Are Appropriate

Interest Rates and Inflation

What causes mortgage rates to go up or down?

How come one day 30-year fixed rates are 6.00% and the next they’re 6.125%?

For many people the vision of a boardroom full of cigar smoking bankers comes to mind when contemplating this question. Or, many believe that the Federal Reserve Bank holds ultimate control with the Federal Funds Rate.

However, the truth of the matter is mortgage rates are entirely determined by the marketplace. Many factors can contribute to the direction of mortgage rates including stock market movements, technical trading patterns of mortgage-backed bonds, geopolitical news but of the most important is inflation.

I have provided a link below to an article that I feel does a good job of explaining the relationship between interest rates and inflation.

The Relationship of Inflation to Interest Rates

As well, here is an excerpt from this article which summarizes the relationship:

When prices increase, your dollar gets to buy less. Over time, prices tend to steadily increase. Hence, your one dollar today is not necessarily equivalent in value to your one dollar tomorrow. A case in point: if you could buy four comic books with your one dollar when you were younger, guess what, Batman? You can’t even buy one these days at that price. That is inflation.

So how is this related to interest rates?

Investors, try to preserve the value of their money by investing in activities that have yields that are either equivalent or higher than the inflation rate (therefore, when their expectation for inflation increases, they will demand a higher interest rate to lend their money). Let’s say that the local interest rate is pegged at 6.5%; the money that you earn, save and invest, should be able to at the very least, match that rate. Why, because at the end of the year, if your money stayed inside the piggy bank, its value would’ve been eroded by that rate. So if you save 100 dollars at the start of the year, at the end of the year its worth would’ve been shaved by $6.50 leaving your $100 worth only $93.5…..

So to wrap up, inflation is one of the factors that affect interest rates. When inflation moves up or down, the tendency is to increase or decrease (mortgage) rate(s) as well.