The Fed’s favorite measure of inflation, Personal Consumption Expenditures (PCE), recently showed that headline inflation rose 0.9% in March. This caused the year over year reading to increase from 6.3% to 6.6%, which is a 40-year high!
Meanwhile, the Consumer Price Index, which also measures inflation but has a more significant weighting towards housing and out of pocket medical expenses, rose by 1.2% in March. This pushed the year over year reading higher from 7.9% to 8.5%, which is the hottest reading in 41 years!
Why is rising inflation significant?
Not only does inflation lead to higher costs of goods, but it 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 higher rate of return to combat the faster pace of erosion due to inflation, causing interest rates to rise, as we’ve seen this year.
The Fed has been under pressure since late last year to take action to address inflation. Note that the Fed has two levers they can pull for tightening the economy – hiking their benchmark Fed Funds Rate and reducing their balance sheet. The Fed Funds Rate is the interest rate for overnight borrowing for banks and it is not the same as mortgage rates.
Hiking the Fed Funds Rate will actually be a good thing for mortgage rates, as the Fed curbs inflation and preserves the fixed return a longer data Bond provides. However, reducing their balance sheet (which means allowing Bonds to fall off their balance sheet and no longer reinvesting in them each month) would cause more supply on the market that has to be absorbed. This can cause mortgage rates to move higher.
At their March 15-16 meeting, the Fed hiked the Fed Funds Rate by 25 basis points while at their meeting this week, they chose a more aggressive 50 basis point hike. They also said that they anticipate ongoing increases to the Fed Funds Rate, with 50 basis point increases likely at the next couple of meetings. During his press conference, Fed Chair Jerome Powell ruled out a 75 basis point hike, which had been a possibility previously.
The Fed also laid out their balance sheet reduction plan. Starting June 1, the Fed will be reducing their balance sheet by $47.5 billion, divided into $30 billion in Treasuries and $17.5 billion in Mortgage-Backed Securities. They will continue to do so each month through August, but in September these figures will double and they will allow $95 billion to runoff ($60 billion in Treasuries and $35 billion in Mortgage-Backed Securities).
At that current pace, the Fed will reduce their roughly $9 trillion balance sheet by $522.5 billion, which doesn’t make too much of a dent. They will also likely have to reverse course once a recession sets in.
The key takeaway is that we will want to continue to watch how the Fed tries to walk the tightrope of hiking and allowing a balance sheet runoff during 2022, as these actions will play a critical role in the direction of Mortgage Bonds and mortgage rates this year.