Fed Meeting to Address Interest Rates and Inflation

Whither inflation?

“Invest in inflation. It’s the only thing going up.”
-Will Rogers

The Federal Reserve’s Federal Open Market Committee (FOMC) begins a two-day meeting tomorrow, and investors are eagerly anticipating the Fed’s latest pronouncement regarding interest rates, and how this will affect credit markets and mortgage rates.

For the past several meetings, the FOMC has renewed its pledge to keep interest rates very low for an “extended period” of time.  The Prime Borrowing Rate has been at or near zero for over a year.  The Fed has stated in the past that this commitment to low rates is dependent upon economic conditions – namely unemployment, suboptimal capacity utilization, and inflationary pressures.  Fed Chief Ben Bernanke said “if these conditions cease to hold and we anticipate changes in the outlook then of course we will respond to that“.

Most economists seem to believe that the Fed is not in a rush to raise rates, as the economic recovery is still in a delicate position.    While recent housing numbers are positive and the manufacturing sector is picking up steam,  unemployment is still running at 9.7 percent, the highest rate since the early 1980s.

The most recent price index reports appear to show that inflation is under control.  The most recent producer price index showed a .7 percent increase in March, and a .1 percent increase when volatile food and energy costs are removed from the equation.

There is a contrarian view about inflation, however, which suggests that inflationary pressures may force the Fed to raise rates sooner rather than later. Jim Bianco of Bianco Reasearch recently posited an interesting theory in a Yahoo! Finance article.  Bianco contends that due to the first-time home buyer tax credit and the way the consumer price index (CPI) is calculated, inflation may be presently much higher than most people believe.

Approximately 40 percent of the CPI is comprised of housing costs, but instead of using actual housing costs, the CPI is calculated using a number called “owner’s equivalent rent” (OER), which is the amount it would cost a homeowner to rent a home equivalent to the one they own.  About two million people have taken advantage of the first-time home buyer tax credit.  The majority of these people were former renters.  The mass exodus of renters from the market has depressed rental costs.  As a result, OER is running significantly lower than actual housing costs, and causing the CPI to appear artificially low.

Bianco’s theory suggests that a correction in the rental market after the expiration of the tax credit will cause the CPI to shoot up quickly.  The CPI is one of the key metrics the Fed uses to evaluate inflation. If this theory proves to be correct, we could see the Fed raising rates sooner than expected.

How high do you think mortgage rates will be by the end of the year?  Join the discussion in the comments section below.