raising interest rates & inflation

Greg Nowell GN842 at CNSVAX.Albany.Edu
Thu Sep 17 14:23:47 PDT 1998

My piece for a real-estate site which I find useful for tracking opinion about the bond market (and also fidgeting with whether one should refinance, etc.) and the mortgage market addresses in part the question of inflation and deflation following an interest rate hike. It can be found at the link below. (Rate Watch #103, www.homeowners.com). Note that the title should be "The Fed: Whose Interest Is It?" 'twas the editor who put in "who's". God save us.

In a word: increased rates decrease the asset value of existing outstanding bonds with fixed yields (adjustable rate bonds adjust). Banks have less to "back" their deposit liabilities. It's not just that there's less of an incentive to borrow at a higher rate; there's less capability in the banking system, following standard accounting, to accommodate new borrowing. The converse is also true. One ofthe reasons the money supply is expanding is that panic buying of long bonds increases bank portfolio values and gives them "new lending capacity." This, in spite of the high discount rate (in real and inflation adjusted terms). But fears taht the price spike in US bonds (high bond prices, low long rates of interest) is temporary have caused the spread between mortgage securities and the long bond to increase (banks are saying: we won't lend long at 30 years at 6.25% just because the 30 year bond is at 5.25%: if the 30 year T bill rises we'll be left holding the bag. So the long rate has stayed molasses like at 6.75-7.00% for a long time while T bills moved low. Note that those rates are for 30 years 0 points. National average mortgage figures frequently cited in the paper include the interest rates paid by people who pay 1 or 2% of the mortgage as "points" to get a lower interest rate).


-- Gregory P. Nowell Associate Professor Department of Political Science, Milne 100 State University of New York 135 Western Ave. Albany, New York 12222

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