Fed Continues Aggressive Rate Hikes to Help Curb Inflation

John Smith
January 1, 2023
5 min read

This year we have seen widespread inflation, in everything from gas prices to our weekly grocery run.

High inflation is significant for many reasons. Besides causing higher prices, inflation is also the arch enemy of fixed investments like Mortgage Bonds because it erodes the buying power of a Bond's fixed rate of return. If inflation is rising, investors demand a rate of return to combat the faster pace of erosion due to inflation, causing interest rates to rise as we’ve seen this year.

How the Fed Is Addressing Inflation

The Fed has been under pressure since late last year to address soaring inflation, and in response they have hiked their benchmark Fed Funds Rate five times so far this year, including their latest aggressive 75 basis point hike at their meeting on September 21. Remember the Fed Funds Rate is the interest rate for overnight borrowing for banks and it is not the same as mortgage rates. When the Fed hikes the Fed Funds Rate, they are trying to slow the economy and curb inflation.

During his press conference after last week’s meeting, Fed Chair Jerome Powell reiterated that the Fed is “strongly committed” to fight inflation, which remains near 40-year highs and well above their 2% target.

The Fed now expects an additional 125 basis points of hikes this year, which may be 75 basis points at their November 2 meeting and 50 basis points at their December 14 meeting. In addition, the Fed anticipates inflation as measured by Core Personal Consumption Expenditures to be at 4.5% at the end of 2022, which is not a lot of progress from current levels towards their goal of 2%.

While Fed rate hikes can be good for mortgage rates if they’re perceived to curb inflation, the Bond market initially digested the Fed’s most recent hike and projections negatively, as they gave the impression that the Fed does not have a handle on inflation, which the Bond market hates.

It will be important to see if investors and the markets believe the Fed and other central banks can get a handle on inflation, as this will play a crucial role in the direction of Mortgage Bonds and mortgage rates this year.

If the Fed is successful in cooling inflation, mortgage rates (which are primarily driven by inflation) should decline. History proves this during rate hike cycles for the past 50 years. But if the market doesn’t believe the Fed can get control of inflation, we could see more volatility in mortgage rates.

Recession Chatter

After last week’s Fed meeting, Powell was also asked whether the Fed could still achieve a “soft landing,” which means they can slowdown or tighten the economy in their attempt to bring inflation under control while avoiding a recession. He replied, “The chances of a soft landing are likely to diminish to the extent that policy needs to be more restrictive, or restrictive for longer. Nonetheless, we're committed to getting inflation back down to 2%.”

This can also be seen in the Fed’s projection for growth, which was revised lower from 1.7% in 2022 to 0.2%. The Fed also believes the unemployment rate will go up to 4.4% next year.

Plus, the 10-year / 2-year Treasury inversion recently achieved the steepest inversion we have seen since 1982. This is unusual as typically you would expect to receive a higher rate of return if you put your money away for 10 years when compared to lesser timeframes. An upside-down yield curve has been a historically accurate recession indicator, as it is a symptom that the economy is slowing.

The bottom line is there is growing consensus for a recession, including Goldman Sachs and Fannie Mae who think that there will in fact be a hard landing and a recession early next year. The World Bank and FedEx CEO Raj Subramaniam also made headlines recently by saying they believe the world is edging toward a global recession.

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