Inflation Picking Up

From 5/16/2005 Wall Street Journal:

56 leading economists surveyed by the WSJ: lifted their inflation forecasts. They now expect the consumer-price index to increase 2.9% on an annual basis in May and 2.7% in November. Those forecasts are higher than in April's survey, when CPI was seen rising 2.6% and 2.5% in May and November, respectively. The most recent government report, for March, showed a rise of 3.1%

If expections of future inflation continue to rise, then the Federal Reserve will be forced to continue to raise the short end of the curve. Currently, December Fed Fund futures are showing a 100% chance of rates going up 50 bps from the present 300 bps and 66% chance of rates going up 75 bps. This will have significant impact on the housing market, particularly the bubble markets in the eastern seaboard and California. These markets are being fueled by exotic loans that offer deep discount adjustable teaser rates and/or interest only payments, which are all priced off the short end of the curve.

How much of difference can these enivitable raises make? As an example, a house in my neighborhood was put on the market for $2.2 million. Assuming $500k down (they made a killing on their last house), my new neighbor will need a loan for $1.7 million. What will they do to afford it? Just like all my other new neighbors, Interest only loan. The current rate for an interest only is about 5%. That equates to monthly payments of $7,083. (I don't know how you can sleep at night with that kind of monthly) Now let's say that my new legal eagle neighbors can afford this (I assume only two lawyers would be dumb enough to do this) . What happens if they delay their purchase 6 months and the interest only rates, which are tied primarily to short term rates such as COFI, LIBOR, and 12-MTA rise another 75 bps? Assuming the most they can pay is $7,083/ month, then if rates went up 75 bps (which is what the Fed Fund futures rates are predicting) the largest loan they could afford would be $1.48 m. This would lower their offering price from $2.2 m to $1.98 m or a 10% decrease.

Of course the seller may choose to stay put if the price decreases too much. The point being that just because the long end of the curve continues to stay absurdly low, don't think that home prices or sales volume in very expensive markets can't be impacted by the short end moving.