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The Federal Reserve is dialing back the pace of its short-term interest rate hikes, but Fed Chairman Jerome Powell is warning of more rate increases to come in the New Year as policymakers remain concerned that inflation will become entrenched.
Wrapping up their final meeting of the year Wednesday, Fed policymakers unanimously approved an expected 50-basis point increase in the federal funds rate to a target range of 4.25 percent to 4.5 percent.
While smaller than the 75-basis point increases implemented by the Fed at its last four meetings, “50 basis points is still a historically large increase and we still have some ways to go,” Powell said at a press conference following the Federal Open Market Committee meeting.
The so-called “dot plot” — a poll of committee members’ projections of how much more rates will have to go up to combat inflation — suggests that the Fed will keep raising rates next year until the federal funds rate is just above 5 percent.
That would require policymakers to implement rate increases next year totaling 75 basis points, or three-quarters of a percentage point. Asked whether the Fed will move to smaller, 25-basis point increases at future meetings, Powell said the more important question is how high rates will go — and how long the Fed will keep them there.
“As we have gone through the course of this year … and we saw how strong inflation was and how persistent, it was important to move quickly. The speed and pace was the most important thing,” Powell said. “Now that we’re coming to the end of this year, we have raised 425 basis points this year and we’re into restrictive territory. It’s now not so important how fast we go — it’s far more important to think what is the ultimate level and then at a certain point, the question will become, how long do we remain restrictive? I’d say the most important question now is no longer the speed.”
While higher retail profit margins have been a key factor driving inflation, Fed Vice Chair Lael Brainard recently noted there “is ample room for margin recompression to help reduce goods inflation as demand cools, supply constraints ease, and inventories increase.”
But in their latest forecast, Fed policymakers see core PCE inflation hitting 3.5 percent next year, up from 3.1 percent in their last forecast and far above the Fed’s 2 percent goal for personal consumption expenditures (PCE) — prices excluding food and energy.
Fed policymakers “continue to see risks to inflation as weighted to the upside,” Powell said. “Despite elevated inflation, longer term inflation expectations appear to remain well anchored as reflected in a broad range of surveys of households, businesses and forecasters, as well as measures from financial markets. But that is not grounds for complacency. The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.”
The Fed’s higher inflation and rate forecasts are “hard to square with the improving data,” said Pantheon Macroeconomics Chief Economist Ian Shepherdson, in a note to clients.
“The inflation forecasts suggest either that the Fed has lost faith in the idea that margin compression will drive down inflation — even though Vice Chair Brainard made this point forcefully just a few weeks ago — or that it is less confident that higher unemployment will reduce wage inflation or both.”
“We see no reason to make these judgments in light of the data released since the September forecast round, and we are strongly of the view that inflation will substantially undershoot the Fed’s forecasts next year,” Shepherdson wrote. “If policymakers implement all the hikes they now expect, they will have done too much.”
Energy prices are another key driver of inflation, exacerbated by the ongoing war in Ukraine.
“Russia’s war against Ukraine is causing tremendous human and economic hardship,” the Federal Open Market Committee noted. “The war and related events are contributing to upward pressure on inflation and are weighing on global economic activity. The committee is highly attentive to inflation risks.”
While the Fed doesn’t have direct control over long-term rates on mortgages and government bonds, Powell said policymakers will continue to trim the Fed’s holdings of Treasurys and mortgage-backed securities, which ballooned to nearly $9 trillion during the pandemic.
In an implementation note, the Fed said it would continue to let $60 billion in Treasurys and $35 billion in mortgages roll off its books each month. Throughout much of the pandemic, the Fed was adding $40 billion a month in mortgages and $80 billion a month in Treasurys to the central bank’s balance sheet, which helped push rates to historic lows.
Because mortgage rates move inversely to demand, the Fed’s withdrawal from bond markets in March contributed to long-term rate increases that have only recently subsided.
Demand for purchase loans has increased in five out of the last six weeks as mortgage rates continue to retreat from 2022 highs registered in October, according to a weekly survey of lenders by the Mortgage Bankers Association.
Mortgage rates retreat from 2022 highs
The Optimal Blue Mortgage Market Indices, which are updated daily, show that since hitting a 2022 high of 7.16 percent on Oct. 24, 30-year fixed-rate mortgages have fallen by 86 basis points after dropping to 6.3 percent Tuesday.
“Interestingly, mortgage market participants are still optimistic that interest rates will actually fall in 2023,” Marty Green, principal with mortgage law firm Polunsky Beitel Green, said in a statement. “The question is whether the market is just being overly optimistic or whether the market actually has a better reading on inflation and the possible effects of a recession than the Federal Reserve does.”
Now that it’s clear that the Federal Reserve has begun slowing the pace of short-term interest rate hikes, the wide “spread” between 10-year Treasury yields and mortgage rates could return to something closer to historical norms as prepayment fears ease.
There has already been some easing in the primary mortgage spread, but mortgage rates would be nearly 1 percent lower today if the spread was closer to the six-year average of 208 basis points (2.08 percentage points).
Surveys by Fannie Mae show homebuyer sentiment improved slightly in November for the first time in nine months. Most consumers still expect mortgage rates to keep rising, but a growing number are starting to share the views of some economists who think rates may have peaked.
Mortgage rates expected to come down
Source: Fannie Mae and MBA forecasts, November 2022
Fannie Mae economists think mortgage rates will steadily decline over the next two years, dropping below 6 percent in late 2024. Economists at the Mortgage Bankers Association project a more dramatic decline in rates with 30-year fixed-rate loans retreating below 6 percent next year and well below 5 percent in 2024.