Can the inflation drop improve mortgage interest rates?

Homebuyers and owners hoping to refinance may have become so accustomed to higher mortgage rates in recent years that they stopped looking for affordable opportunities. However, that may be a mistake worth correcting heading into the new year. Mortgage interest rates are down by around a full percentage point, on average, from where they started in January. And there's real reason to be optimistic about them declining further, perhaps even before the year is out.

The Federal Reserve has issued three interest rate cuts in the final four months of the year, combining for a federal funds rate that is 75 basis points lower than it was on September 1. Accordingly, mortgage interest rates have since been hovering around their lowest levels since 2022. And more encouraging news was released on Thursday.

In the first inflation report to be issued since the government shutdown concluded, inflation was shown to come at 2.7% in November, lower than the 3% it had been rising at and closing in on the 2% goal the Federal Reserve has long pursued. And this could be the kind of news that buyers and homeowners were looking for, as it has the potential to further improve mortgage interest rates. Below, we'll explain why.

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Can the inflation drop improve mortgage interest rates?

In short, yes, the inflation drop can improve the mortgage interest rate climate, even if it's in an indirect way. An inflation decline can be the motivation for the Federal Reserve to continue to cut interest rates, which can help drive mortgage interest rates lower.

While mortgage rates are influenced by multiple factors, including the 10-year Treasury yield, Fed rate activity can push rates up or down, even before a formal cut or hike is issued, as many lenders will adjust their offers preemptively. A lower inflation rate, in other words, can and likely will encourage the central bank to continue its interest rate cut campaign. This was one of the key reasons why the Fed lowered rates in 2024 and then paused in early 2025 as inflation ticked up again.

But that's not the only factor that may cause the Fed to continue cutting rates, perhaps as soon as the next Fed meeting in January. The unemployment report that was released this week showed an increase there. Now at 4.6%, that's the highest unemployment rate since September 2021. The Federal Reserve has some power here, however, to stimulate the economy via lower interest rates. And, combined with a lower inflation rate as justification, it may do just that.

So, two factors could spark further Fed rate cuts: a lower inflation rate and a higher unemployment one. That, in turn, could lead to a decline in mortgage interest rates. 

These are complicated and interwoven data points, however, and the path to a consistent decline in mortgage interest rates remains a convoluted one. The CME Group's FedWatch tool, for example, only lists a January Fed rate cut at a 26% likelihood right now. And the Fed may also interpret this week's new data as justification for keeping interest rates where they are, versus moving them downward again. That could stagnate any improvement in the mortgage rate climate as a result. 

Still, the fact that additional Fed rate cuts are even possible now and that mortgage interest rates may decline again is a positive development for borrowers. It was only August 2023 when mortgage interest rates were at their highest level since 2000. So any movement here is encouraging, even if it will take more time and patience on behalf of borrowers to get mortgage rates as low as they'd prefer.

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The bottom line

A lot has happened to cause mortgage rates to decline in 2025 and a variety of factors are in play for them to continue to fall in the weeks and months ahead. The good news for borrowers is that, right now, the interplay of these items (inflation, unemployment, Fed rate policy) are working in their favor and they're likely to result in even lower mortgage rates soon. This all being said, predicting the future of interest rates is impossible to do with precision. So if today's rates are already low enough to fit your budget, whether you're buying or refinancing, consider locking one in now. You can always refinance to an even lower one if and when they materialize in the future and you'll start saving on interest costs in the interim.