The Scoop on Inflation and Its Impact on Home Loan Rates
The Scoop on Inflation and Its Impact on Home Loan Rates
By Gary Umholtz
CPI, PPI, PCE...sounds like a nice bowl of alphabet soup. But did you know that what lies behind these letters impacts not only YOU every single day...it also bears a very heavy influence on the direction of home loan rates? So pull up a chair, grab a spoon, and let's dig in to learn more.
First, let's break down what these letters mean. CPI stands for the "Consumer Price Index," and just like it sounds, it is a measure of prices that consumers are paying for goods and services here in the United States. PPI stands for the "Producer Price Index," which is a measure of the prices that manufacturers and producers are paying to create these goods and services. PCE stands for "Personal Consumption Expenditures," which is another measure of how much we as consumers are paying for all the items we purchase.
Each of these readings is very different–but they all serve to measure inflation, which is the relative increase in the prices for goods and services...or a decline in the purchasing price of a dollar.
Consumer Price Index - The CPI was first initiated during World War I. This was a time when prices were increasing very rapidly, so employers needed to develop a system to adjust wages along with the increasing cost of living associated with higher costs of goods and services. The Bureau of Labor Statistics determined a basic "basket of goods" that an average person might buy on a regular basis, and then began monitoring the prices of items in this basket on a monthly basis, for cities across the US. As spending habits changed over the years, the basket of goods and areas surveyed changed–but the basic philosophy has remained the same.
What does an average CPI "basket" look like? Here's a sample. How does it compare with your monthly shopping cart?
▪ Food and Beverages (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
▪ Housing (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
▪ Apparel (men's shirts and sweaters, women's dresses, jewelry)
▪ Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
▪ Medical Care (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
▪ Recreation (televisions, toys, pets and pet products, sports equipment, admissions)
▪ Education and Communication (college tuition, postage, telephone services
▪ Other Goods and Services (tobacco and smoking products, haircuts and other personal services, funeral expenses)
So how is this data collected? Every month, researchers from the Bureau of Labor Statistics visit or call thousands of stores and offices to obtain pricing information, ultimately tracking and pricing about 80,000 items per month. The numbers are reported on a monthly basis, using the time period for the years 1982-1984 as a baseline, assigning the basket a level of 100. So if the new pricing levels come in at 189, you could make the connection that something that cost $100 in 1982-1984 might now cost $189. On a monthly basis, however, what is reported is the percentage increase (or decrease) from the prior month, and then also the percentage change from last year.
For an interesting – and somewhat sobering – look at how the buying power of your dollar has changed over the years, try out the inflation calculator from the Bureau of Labor Statistics:
Producer Price Index - The PPI is somewhat different than the Consumer Price Index (CPI), as it measures the costs that a producer or wholesaler pays for the items they need to create goods and services. This can often give a foreshadowing of potential increases to consumer prices...but not always. In some cases, the producer is unable to pass along their increased costs, and simply has to take a lower profit margin on the item in question. Similarly to CPI, the data for PPI is released in a percentage format, indicating the increase or decrease in prices paid by the producer relative to last month and also last year.
It's fascinating to watch these particular economic reports get released each month, as the Producer Price Index is always released just a few days before the Consumer Price Index, and it's always a subject of much speculation to see if the increases in producer costs have been passed on to consumers...or not.
Personal Consumption Expenditures - The PCE is somewhat similar to CPI, as it measures price changes in consumer goods and services. But there is one primary difference. Remember the "basket of goods" described in the CPI? PCE takes a slightly different look at this basket, as it presumes that consumers are smart enough not to keep buying a particular item that has gone up in price compared to something else similar.
For example, if oranges become expensive due to a crop freeze, a savvy consumer might decide to buy a different kind of fruit or juice in the meantime. Where CPI leaves that expensive item in their fixed basket of goods, PCE takes smart shopping into consideration. This is why many people speculate that the Federal Reserve actually places more weight on PCE, as it may more accurately depict a consumer's true behavior and spending habits.
The Impact on Home Loan Rates
Imagine for a moment that you are going to lend your very own money to someone to buy a house. So you go through all the paces to determine this person is a good credit risk, you do the loan, and you start receiving $1,500 per month as your regular payment. You then of course take that $1,500 and start loading up your shopping cart with the goods and services you need on a monthly basis...food, clothing, medicine, gas, etc.
But over time, you notice something happening. Every month, you are getting slightly less in your cart than you did the month before, for that same $1,500 you are spending. Why? Because costs are on the rise–that's inflation.
Now imagine that you are once again going to lend your very own money to another person to buy a house. You go through all the paces once again, and determine that the person is a good credit risk. You want the same shopping cart full of "stuff" that you got last time in return for doing the loan, but this time you realize that you can no longer get that same cart full with $1,500. Due to inflation, you now need $1,700 to buy those same goods and services.
So what does this mean for the interest rate you will charge this second person? It means you will need to charge a higher interest rate to compensate you for the ongoing impact of inflation. And that is why home loan rates change when there is a fear of inflation in the air, as lenders need to offset the impact of inflation over the years, which will erode the value of the dollars they are receiving over time. And that's also why it makes sense to work with a smart home loan professional one who can be watching these types of indicators and keeping you informed and advised.
Gary Umholtz with RPM Mortgage can be reached at (707) 343-9510 or firstname.lastname@example.org for a no obligation consultation.