The Fed’s Continued Fight Against Inflation
All eyes this week were on the U.S. Federal Reserve (and other central banks) for its last policy meeting of the year. The Fed did all that was expected Wednesday: raising rates 50 BPS to the highest level in 15 years while warning it’s only the end of the beginning and there’s still a way to go. It also poured cold water on a dovish shift in policy. The 50 BPS hike was expected, but the Summary of Economic Projections (dot plot) was the real focus. The FOMC increased its forecast for the fed funds rate in 2023 by 50 BPS; instead of the markets seeing another 25 BPS of tightening in 2023, expectations are now for another 75.
Mortgage rates have fallen since Fed Chair Powell last month suggested a policy shift was coming: that after four consecutive 75 BPS rate hikes the Fed would soon slow, then pause hikes, before eventually cutting rates in the second half of next year in response to a weaker economy and falling inflation. But Fed officials stood a little more hawkish on Wednesday than recent investor sentiment contributing to easier financial conditions would hope, anticipating “that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.”
The Labor Market and Inflation
The latest dot plot showed a terminal rate of 5.10% fed funds target (it currently sits at 4.25% to 4.5%) in 2023 with no rate cuts foreseen next year. Powell has previously emphasized that the pace of tightening is less significant than the peak and the duration of rates at a sufficiently restrictive level. He stated several times in his press conference that “the historical record cautions strongly against prematurely loosening policy.” Though that means more softening of labor market conditions are headed our way, investors have still taken the hint that the Fed is more or less done with this tightening cycle, which has been the steepest since Paul Volcker led the central bank in the early 1980s.
This latest rate hike won’t be the last and the Fed wrapping up its tightening cycle will be welcome relief for the bond market.
Powell has identified three main components driving inflation: goods, housing, and services wages. Prices of goods rose from supply chain bottlenecks due to the pandemic, and this appears to be more or less over. Housing increases, driven by rental inflation, should begin to fade in the middle of next year. Most crucially, the wages part is the driver for the Fed’s thinking and decision-making. The Fed is looking at a historically tight labor market, and is trying to avoid the 1970s wage-price spiral.
Rising unemployment is a good thing (to an extent) to slow wage rises and thus inflation, but perhaps not for long as we shift from seeing ‘bad data’ as being ‘good’ to bad data being bad because it is a signal the economy is weakening faster and worse than most expected.
Winning the Good Fight
Inflation is and will remain an issue for some time to come. Consumer-price increases have begun a more pronounced slowdown from their 40-year high earlier this year as the Fed slowly gains ground against inflation. U.S. short-term inflation expectations, which the Fed does take into its calculus, eased again to the lowest level in more than a year, helped by falling gasoline prices. CPI came in at 7.1% on Tuesday, below expectations, however the Fed became more hawkish, which is a signal that it is too early to take a victory lap.
The inversion of the yield curve is back towards where it was during the deep and painful recessions of the early 1980s and a growing number of economists expect the Fed’s aggressive tightening to tip the U.S. into recession next year. The overnight rate (3.81%) and the 30-year rate (3.49%) inversion is even more interesting in the context of quantitative tightening. Lower long term rates made sense when the Fed was building its balance sheet, not necessarily when letting the balance sheet runoff. The Fed’s most recent quantitative easing helped send home prices to new record highs, pushing housing affordability to its lowest level since 1986. QE pulls demand forward, which does not bode well for the housing market.
Pipeline hedgers are once again looking at laggy loan marks, sensitive MSR multiples, and ongoing renegotiation requests (to say nothing of margin calls). However, we have seen origination activity pick up recently with mortgage rates dropping. The Fed will eventually reach its peak target rate, pause, allow roll off to continue, and let the economy adjust. This week is historically the last week of the year to show any reasonable level of trade volume. The holidays in the second half of December and summer vacations in the second half of August are the lightest weeks for traders.