CPIAdjusted Real Rates

To understand whether current interest rates sit high or low, adjust the nominal (quoted) rates for the annual rate of increase in the CPI.6 The cost of money is cheap when real mortgage rates are low, and expensive when real market rates are high.

As you can see from Table 4.2, mortgage borrowers today pay a real rate of around 3.5 percent. Viewed correctly, history suggests that, as long as

6 The nominal mortgage interest rate less the annual percentage increase in the CPI equals what economists call the real rate of interest.

Table 4.2 Comparing Nominal and Real Rates of Interest

Years Nominal Rate (%) CPI Increase (%) Real Rate (%)

1945

4.0

2.3

1.7

1950

4.5

1.3

3.2

1955

5.0

-0.4

5.6

1960

5.0

1.7

3.3

1965

5.89

1.6

4.29

1970

8.56

5.7

2.86

1975

9.14

9.1

.04

1980

13.95

13.5

.45

1990

10.08

5.4

4.68

1995

7.86

2.8

5.06

2002

6.5

2.05

4.0

2007

6.50 (est.)

3.0 (est.)

3.50 (est.)

the chairman of the Federal Reserve Board, Ben Bernake, keeps inflation low, nominal and real interest rates are likely to remain below 7.0—at most 8.0—percent.

No one predicts that ARM rates will push past their annual or lifetime caps within the foreseeable future. In terms of expected inflation, ARMs do not present much risk of payment shock.7 In contrast, look at the period 1970 to 1980 when inflation leaped up. Real rates fell below their historical norms. In response, mortgage rates skyrocketed. Financial markets came to believe that high inflation was built into the country's economic future.

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