U.S. Markets closed

The Fed is happy to see the first import price rise in 5 months

Brent Nyitray, Sr Real Estate Analyst

Import prices are an important driver of inflation

The Bureau of Labor Statistics releases its U.S. Import and Export Price Indices monthly. The report keeps track of import prices by locality, type, and whether fuel or non-fuel. It also separates commodities and non-commodities. Commodity prices tend to be more volatile than non-commodity prices, so it makes sense to strip them out to get a view of underlying inflation. The U.S. inflation indices, the Consumer Price Index and the Producer Price Index, do the same thing—they give the headline number, then strip out food and energy.

(Read more: Annaly Capital Management portfolio yield continues to fall)

Inflation isn’t the Fed’s biggest concern at the moment. If anything, it’s worried that inflation is too low. It has referred to failing on both sides of its dual mandate, which means it’s not enough to keep inflation low. If inflation is too low, the Fed needs to increase it. This makes sense when you think of monetary policy at the zero bound. With interest rates as low as possible (they can’t go below zero), falling inflation (or even deflation) causes real interest rates to rise. Real interest rates are simply nominal interest rates (the rates you read in the Wall Street Journal) less the inflation rate. Deflation in the context of 0% interest rates is the exact problem Japan has.

(Read more: Mortgage REITs get crushed as rates increase)

Highlights of the report

U.S. import prices rose 0.6% in July, after declining 0.4% in June. Fuels were mixed, with petroleum contributing positively and natural gas declining. Import prices rose 1% year-over-year. Autos drove the decline, with prices dropping the most since 1992. Ex-fuel prices fell 0.5%.

Impact on mortgage REITs

Given the muted growth in import prices (partially driven by a stronger dollar), the Fed is anticipating keeping interest rates as low as possible and using other tools, like asset purchases (quantitative easing), to try to spur some economic growth. So far, there’s been no evidence of inflation—mainly because there’s been extremely modest wage inflation. The classic “wage-price spiral” doesn’t really work when wages aren’t cooperating.

(Read more: Radar Logic futures curve predicts flat real estate prices until September 2014)

This should mean that the mortgage REITs—like Annaly (NLY), MFA Financial (MFA), American Capital (AGNC), Capstead (CMO), and Hatteras (HTS)—continue to operate in the same environment they have had for the last several years, with low returns on assets combined with low borrowing costs. That said, the Fed has signaled that it may start winding down QE sometime this fall. As a result, mortgage REITs have gotten hammered as rates rise. If inflation drops down towards zero, the Fed will probably keep quantitative easing in place because it fears deflation more than anything. If interest rates are at the zero bound, and inflation drops below zero, then real (inflation-adjusted) interest rates are rising, which is the last thing the Fed wants to see right now.

More From Market Realist