Markets did not like today’s Consumer Price Index figures which came in higher than expected. However, the downbeat mood this morning is not enough to reverse the recent downward trend in mortgage rates.

The chart at right shows CPI over the past two years and the band collars the Fed’s articulated “comfort zone” for inflation.

The far left of the chart represents the few months before the Federal Reserve began raising the Fed Funds Rate from 1.000%.

The second highest peak represents where the Fed made its last FFR increase to 5.250%.

The Fed has not changed the FFR since June 2006 while it waits to see the impacts of its prior rate hikes. According to the chart, the hikes helped to bring CPI back to a comfortable range and today’s increase still registered within tolerance levels.

This is one reason why the surprise upside to CPI is not causing damage to mortgage rate shoppers.

Source
Consumer Prices Jump 0.2% On Higher Food, Medical Costs
Jeff Bater
Wall Street Journal Online, February 21, 2007 9:37 a.m.
http://online.wsj.com/article/SB117206379493714880.html?mod=home_whats_news_us

Interest rates are currently inverted, a market situation in which the longer you commit to lending your money, the less your return on investment. It’s counter-intuitive so let’s delve a little deeper.

Imagine if a friend asked you to borrow money for two years and you charged him interest on that money. There are some risks in lending:

1. The risk of not getting paid back
2. The risk that the money could have earned more for you somewhere else
3. The risk that the value of the dollar will be lower when you get your money back

The more risk you take, the higher the interest rate you should expect on your money. This is Risk versus Return at its finest. So, if that same friend wanted the money for 10 years instead of two years, you would expect a higher return because your risk is higher on all of the points above.

1. He could lose his ability to repay you in those 10 years
2. You could have had countless other investment opportunities over those 10 years
3. The value of the dollar could swing wildly in those 10 years

In an inverted yield curve scenario, the 10 year program actually pays less than the two year. The theoretical risk is much, much higher over 10 years, but the "reward" is lower.

The inverted yield curve is one of the big reasons why today’s short-term ARM and long-term fixed mortgage rates show very little difference.

The markets continue to show their appreciation for Fed Chairman Bernanke’s testimony yesterday and mortgage rates are falling in response.

So, why do the Chairman’s words hold such sway over global markets? Simple. Buying and selling U.S. dollar-denominated securities is an integral part of central banking fiscal management policies worldwide. When the Chairman says that inflation is subsiding, it really means that the dollar will not be expected to lose value.

That’s what inflation is, after all. It’s the erosion of the dollar’s purchasing power.

If the dollar is expected to lose value, countries that hold U.S. dollars in reserve are likely to sell them to stave off losses. Selling dollars introduces more supply into the marketplace and more supply leads to lower values.

Ben Bernanke’s testimony yesterday (temporarily) put to rest the whispers about the Fed being scared of runaway inflation. Markets are adjusting their expectations — and their portfolios — to plan for a stronger dollar in the months ahead.

Addressing the Senate Banking Committee this morning, Fed Chairman Ben Bernanke gave the speech that most people expected: The current monetary policy (read: Fed Funds Rate) is at a level that both sustains economic growth, and tempers inflation pressures.

In addition, inflation expectations "appear to have remain contained," Bernanke said. He called that "encouraging" and this is a good sign for markets because inflation can be a Self-Fulfilling Prophecy. When people believe that inflation will happen, they prepare for inflation, and in doing so, it makes inflation actually happen.

A large part of the Fed’s role is to manage inflation expectations and Bernanke seems pleased with the back-and-forth between his team and global investors.

Bernanke prepared remarks also alluded to his concern that inflation won’t subside as expected. He cautioned that the Federal Reserve is "prepared to take action", if necessary. Despite that statement, however, markets are generally pleased with the testimony and mortgage rates are falling this morning.