Why is the Fed saying it’s hiking if rates are at 4-month lows?

Mortgage rates officially hit four-month lows after this week’s inflation data. Despite recent progress, Fed officials continue to talk about keeping rates high “for as long as possible.” Who is right?

First, we know that mortgage rates are at 4-month lows because that claim is based on the past as opposed to the future. You’ll have to go back to September 12 to see anything lower for the average lender. We also know that inflation has been the driving force behind the huge interest rate volatility seen over the past 12 months.

In particular, the Consumer Price Index (CPI) has been at the crime scene for most of the biggest rate moves. Until November, all but one of these big moves were toward higher rates, but things have changed since then.

Rates respond to inflation data because rates are based on bonds and inflation directly affects bond yields. They are responding more than usual last year, as inflation jumped to the fastest pace in 40 years in 2022. Recent reports show progress on the inflation front, so longer-term rates like mortgages show some hope for the future.

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All of the above makes logical sense, but why do Fed officials continue to say more rate hikes are needed and that rates will remain as high as possible?

One source of confusion is that the Fed Funds Rate (which the Fed increases/decreases/etc) is different from mortgage rates. The Fed Funds Rate is applied to overnight lending between large institutions and has the greatest impact on the shortest-dated bonds. The longer a bond is held, the more it can deviate from the Fed rate.

The Fed sees a potential ceiling spike in inflation and thinks, “That’s great, but let’s not get complacent. We need to get inflation back into the 2% range.”

The Fed keeps inflation low by keeping short-term rates high. This impedes the flow of credit in the financial market and eventually slows economic demand enough that sellers are forced to lower prices. This is an oversimplified idea anyway.

While some may argue that the Fed has raised enough that inflation will surely continue to fall, there is concern about repeating the mistake of the 80s when the Fed cut rates too quickly and inflation reignited. They are particularly vulnerable to this risk due to the still very strong job market.

In other words, the Fed must stick to its tight, inflation-fighting script or risk the market getting excited at the thought of potential rate cuts. Such exuberance could undo some of the recent progress made against inflation.

Despite the Fed’s tough talk, they are beginning to acknowledge that it is time to slow the pace of rate hikes. At this point, the market only sees the Fed as likely to hike twice more and by a smaller amount than last time. After the Fed stopped hiking, they joined forces to keep interest rates high for as long as possible.

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It is impossible to know how long “as long as possible” will last. What we do know is that the rate path will take cues from inflation and employment data. If inflation continues to fall and unemployment rises further, the market will increasingly bet on Fed rate cuts. For now, it would not be surprising to see the interest rate forecast settle on a narrower, more sideways pattern as inflation begins to confirm a reversal and unemployment is still very low.

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The silver lining is the fact that long-term rates begin their decline long before the Fed does when it comes to these hike/cut cycles. The chart below shows how this plays out with 10-year Treasury yields (highly correlated with mortgage rates) and the latest Fed Funds Rate.

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We won’t know until February 1 whether the Fed will cut the size of its next rate hike. Now and then, markets will pay close attention to economic data, looking for any evidence of a revival in inflation or an acceleration in wage growth. The data available for the next 3 weeks is not in the same league as the data of the last 2 weeks, so the markets cannot act with much confidence until we hear from the Fed.

The bond market and most mortgage lenders on Monday were Martin Luther King Jr. will be closed for the holiday.

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