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Spike in Interest Rates Could Choke Recovery
Low Rates Had Sparked Consumer Spending

By Neil Irwin
Washington Post Staff Writer
Friday, June 12, 2009

Rising long-term interest rates are making it more expensive for home buyers, corporations and the U.S. government to borrow money, threatening to further stifle an already weak economy.

In just the past two weeks, the rate on a 30-year, fixed-rate mortgage has risen to 5.6 percent from 4.9 percent, ending a boom in refinancing and working against a budding recovery in the housing market. Rates on corporate borrowing have also risen, making it more expensive for companies to expand. And the government has been forced to pay more to finance its deficit.

Since the beginning of the year, historically low mortgage rates have had a twin benefit for the economy: They have allowed homeowners to refinance about $1.5 trillion worth of mortgages, thus lowering monthly payments and leaving people with more money to spend on goods and services. Low rates have also created greater incentive for people to buy homes, despite continuing troubles in the housing market.

The abrupt rise in rates has removed that key stimulant for the economy.

The rise has many causes, some of which reflect good news. As investors have grown more confident about the future, for example, they have become more inclined to put money in risky investments, such as the stock market, rather than lending it to the U.S. government and to government-backed mortgage companies.

But other causes give more reason for worry. Investors around the world are increasingly fearful that Congress and the Obama administration will be unwilling to bring taxes and spending in line in the years ahead. That makes the U.S. government appear to be a riskier borrower, leading those who lend to it to demand higher interest payments.

The Federal Reserve now finds itself in a box. It could try to lower rates by buying government debt. It has already said it would buy $1.5 trillion in U.S. Treasuries and mortgage-related securities this year to try to stimulate growth.

But doing so would likely only deepen fears that the Fed will print money to fund government deficits in the future. That possibility -- while rejected by Fed officials and many mainstream economists -- means that expanding purchases might not have the intended effect of lowering rates. It could even drive them up further.

Rates remain very low by historical levels. But the yield on 10-year Treasury bonds has risen to almost 4 percent this week from 3.1 percent on March 14. (It edged down yesterday to 3.9 percent.)

A wide range of other rates are essentially moving in tandem with that rate, including mortgages. That shift has far-reaching implications.

"Households really have no capacity to afford higher rates at this point," said Scott Anderson, a senior economist at Wells Fargo. "It affects the cost of any long-term borrowing a consumer or business might do, whether it's auto loans, mortgages or business credit."

The number of refinance transactions has dropped 62 percent since early April, according to a survey by the Mortgage Bankers Association.

Amber Sutton, a District resident, was among those poised to benefit from low mortgage rates. For weeks, she had been considering refinancing her mortgage. By reducing her rate from 5.5 percent to well under 5 percent, she would have been able to reduce her monthly payment by about $200 -- money that would have been available to plow into expanding her business, dog day-care Dogtopia in Woodbridge.

"I would have put the savings toward opening a new location in one or two years," Sutton said. Now, with rates higher, refinancing wouldn't offer her any savings.

"Borrowers who were approved but didn't lock their rate are just walking away," said Christopher Cruise, a senior loan officer at GotEHomeLoans in Bethesda. "They could have saved a few hundred dollars a month at last month's rates, but it makes no sense for them to refinance now."

Even with the benefits provided by refinancing to homeowners, consumer spending has remained soft. In May, retail sales rose 0.5 percent, the Commerce Department said yesterday. But that number was inflated by a sharp rise in gasoline prices that inflated sales at gas stations.

So far, home-purchase activity has been relatively stable, according to a range of indicators. But if the higher mortgage rates persist, it could put a damper on a fragile housing market. Home sales have stabilized in the past few months, though at a very low level, spurred in part by lower rates.

"The increase so far has not really been enough to choke off home buying," said Jay Brinkmann, chief economist at the Mortgage Bankers Association. He added, though, that "higher rates might lead them to pay a lower price or look for a smaller home."

Fed leaders have generally viewed the rise in government borrowing rates as benign, reflecting money flooding away from the safe haven of Treasury bonds and into riskier investments. That, in the view of Fed officials, creates a self-correcting mechanism. If rates rise so much as to choke off economic growth, the resulting weakness in the economy will drive rates back down again.

They are more concerned about widespread discussion of the idea that the Fed will buy up Treasury bonds far into the future in a manner that generates high inflation. Lawmakers and television commentators alike have broached that possibility, called "monetizing the debt" with increasing frequency in recent weeks.

"The Federal Reserve will not monetize the debt," Fed Chairman Ben S. Bernanke said at a congressional hearing last week. Fed leaders take some solace from the fact that inflation expectations remain low.

Nonetheless, the mere existence of that chatter could make the Fed less inclined to ramp up its asset purchases at its next rate-setting meeting scheduled for June 23 and 24.

Staff writer Ylan Q. Mui contributed to this report.

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