Home Buyers Don't Want To Bet On Low Inflation

Ironically, just as the Treasury Dept. has decided to increase its reliance on shorter-term borrowing to reduce its interest costs, consumers have been moving in exactly the opposite direction. In an unprecedented move, new home buyers and people who are refinancing their mortgages are ignoring the current sizable interest savings offered by adjustable-rate mortgages (ARMs) and choosing to take out fixed-rate loans instead.

In essence, says economist Michael Moran of Daiwa Securities America Inc., "the Treasury is making an implicit bet that inflation won't reignite and heat up short rates, while the borrowing public is saying that the risk of a pickup in inflation is too great to ignore."

All through the 1980s, notes Moran, the popularity of ARMs rose and fell with the size of the spread between interest rates on fixed-rate mortgages and the initial rates on ARMs. Whenever the spread widened significantly, more households opted for ARMs than for fixed-rate loans. In the past year, however, even though the yield spread has widened to nearly three percentage points and initial rates are well below 5%, borrowers have overwhelmingly chosen fixed-rate mortgages (chart).

The difference from past periods, of course, is the low absolute levels of both short- and long-term rates. "Most borrowers are probably convinced that interest rates can only move up from here on in," says Moran, "and they want the security of fixed-rate financing."

For the moment, all of this seems good for the economy. In fact, one reason the Treasury changed its borrowing mix may have been to nudge long rates down and thus stimulate housing and bolster the sluggish expansion.

Monetary policy-making could become trickier in the future, though. With more households insulated from the income-constraining effects of rising interest rates, the Federal Reserve might have to tighten more when the economy starts overheating. But at the same time, warns Moran, the Fed could face political pressures to keep rates low to avoid adding to the deficit.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE