The rate for 30-year fixed rate mortgages jumped from 5.5% to 6.2% in February while 1-year Treasury bill rates fell from 2.3% to 2.1% and then dipped below 2.0% in early March. Financial markets remain more volatile than usual but the range of short term fluctuations no longer includes the huge rate premiums for asset backed loans that effectively denied capital to many borrowers last fall.

Aggressive monetary easing is keeping the subprime mortgage losses from seriously reducing capital availability in the rest of the economy. However, the Federal Reserve board could not insulate the rest of the economy from the confidence crisis that accompanied the mortgage problem.

The brief rate divergence is consistent with the current unusual economic and financial environment. The plunge in short rates results from the aggressive pumping of funds into financial markets by the Federal Reserve Board and other central banks. Investors are holding many of these funds in safe, short term government securities until they invest them elsewhere. And they are cautious about selling safe, albeit low yield, investment and buying higher yield, longer term assets since there is still uncertainty about the value of all fixed assets. Some are mortgage related; others may drop sharply in value in a slowing economy. Also, investors have already priced in another 50 basis point or more cut in the FRB discount rate in two weeks.

At the same time the uncertainty about the value of longer term assets has increased the risk premium that investors need to buy them. The recent surge in inflation is also contributing to higher long term rates. The equilibrium for mortgage rates is the sum of the cost of short term funds plus inflation expectations. While still contained, inflation expectations have increased with $100 plus oil, soaring food costs and rapidly rising US import prices as the exchange value of the $US continues to fall.

The consequence for construction is that homes have become less affordable over the last month and the early 2008 surge in mortgage refinancing application has been reversed.

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