Mortgages | Why does the increase in borrowing costs increase inflation, even though interest rate hikes should curb it?

Economic discussion has been dominated during the summer and autumn by an accelerating rise in prices, i.e. inflation, and increases in the central banks’ key interest rates, which are aimed at curbing the rate of inflation.

The most important task of central banks is to take care of price stability. The medium-term objective of the European Central Bank (ECB) is to keep the inflation rate at 2 percent.

In order to curb inflation that has accelerated well above its target, the ECB is raising its key interest rates. In July, the ECB raised its key interest rates for the first time since 2011, then by 0.50 percentage points. At the beginning of September, the central bank raised key interest rates once again, historically with a one-time increase of 0.75 percentage points.

The increase in key interest rates and market interest rates reduces household consumption and business investments, which leads to a slowdown in economic growth over time.

The slowing effect of policy interest rate increases, i.e. tightening of monetary policy, on the inflation rate usually begins to be seen in about six months and reaches its full effect within a good year.

Read more: The European Central Bank tightens monetary policy more than ever and warns of economic stagnation

Statistics Finland published its latest consumer price index on Friday. It is a long-term statistic that describes Finland’s inflation rate.

The inflation rate, or the annual change in consumer prices, was 8.1 percent in September. According to Statistics Finland, the acceleration of inflation was caused by, among other things, the rise in the price of electricity and the average interest rate on mortgages. The effect of the average mortgage interest rate on the inflation rate was 0.3 percentage points.

Chief Actuary Kristiina Nieminen Statistics Finland says that the rise in mortgage interest rates has been taken into account in the Finnish consumer price index since the 1960s.

On Friday, the one-year euribor used as a reference interest rate for mortgages settled at 2.677 percent.

However, the rise in prices is also currently measured by the euro area’s harmonized consumer price index, which has its roots in the early 2000s. In the harmonized index, the member countries use similar methods and commodity baskets.

“The harmonized consumer price index has been made for comparison between EU member states and for the ECB to evaluate price stability,” says Nieminen.

In Statistics Finland’s consumer price index, owner-occupied housing with interest costs is taken into account, but this is not the case in the euro area’s harmonized index.

“It was a joint decision to leave it out. There was no clear shared view on how it should be measured and whether it belongs in the index at all. Is owner-occupied housing seen as an investment in wealth, or is it rather a household expense item? In Finland, we have always thought of owner-occupied housing as an expense item.”

According to Nieminen, the EU is currently considering how owner-occupied housing could also be included in the harmonized consumer price index.

“Today, the ECB would also like to make it part of the harmonized index, so that they can see what inflation is really like, when the costs related to owner-occupied housing are also taken into account.”

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On the third Finnish households have mortgages.

When an increasingly large part of their disposable income goes to mortgage servicing costs due to increased interest rates, households are forced to reduce their consumption. In other words, demand in the economy decreases, which tends to slow down inflation.

It may still cause confusion that the interest rate hikes made by the ECB to curb inflation slightly accelerate inflation in Finland, where the increase in mortgage interest rates is included in the consumer price index.

“Of course, this is what happens when we have interest expenses as part of owner-occupied housing. The ECB’s decision is reflected in the consumer price index, as it were, as a rise in prices.”

However, Nieminen says that the weight of the rise in interest rates on mortgages in Finland’s consumer price index is currently quite small.

“Most of the weight of owner-occupied housing in the consumer price index comes from the acquisition of an apartment and renovations. Interest costs have to change quite a lot before it starts showing up in the index.”

The promontory finally points out that the inflation rate in Finland was 8.4 percent according to the preliminary data of the harmonized index. That is, more than in the national index, which includes the purchase of an owner-occupied home, renovations and mortgage interest costs.

“When something is removed from the commodity basket, the other commodities gain a little more weight. Even one change in the basket can have an impact on the final results. This is good to remember.”