The Fed, Inflation, and a Twist

March 8, 2021

Last Week in Review: The Fed, Inflation, and a Twist 

Home loan rates improved modestly week-over-week as the U.S. bond market attempts to stabilize after a sharp increase in rates. Back on Thursday, February 25th, the 10-year yield hit 1.61% and has since declined back beneath 1.50%. This helped mortgage-backed securities (MBS), which drive home loan rates, to also improve in price/rate.

The Sales Pitch Continues

Inflation is the main driver of interest rates. If inflation or inflation expectations move higher, rates move higher, period. The opposite is true. The Fed has had to put on its sales hat recently by continuing to try and sell to the world that inflation in the U.S. will not hit the Fed’s target of 2% over the long-term for three years.

The Fed has noted that inflation will be “volatile.” What does that mean?

Consumer inflation year-over-year is going to rise sharply in the second quarter of 2021. Here’s why. Oil, lumber, and commodity prices like copper, coffee, and grains are up sharply year-over-year. Oil, which is in many consumer products, hovered near $20 a barrel and is now over $60.

“Would need to see inflation exceed 2% in order to even think about starting to get nervous.” Fed President Evans – 3/3/21

It would not be surprising to see consumer inflation in the mid to high 2% by May, so Mr. Evans and the entire Fed will have to continue to talk down inflation in order to try and keep rates from increasing further.

“Come on baby, let’s do the Twist” – Chubby Checker

The Fed only controls the Fed Funds Rate, an overnight lending rate between banks which impacts short-term loans like credit cards and home equity lines of credit and yes, your savings account at the bank. They do not control long-term rates like mortgages, and proof- positive is the sharp rise in rates in 2021, despite increased bond purchases by the Fed in an effort to stem the rise in rates.

What other tools does the Fed have to try and stabilize long-term rates? The rumor mill is swirling that if rates move higher, the Fed may enforce Operation Twist 3.0. They did it back in 2011, and here’s how it works.

The Fed will sell short-term bonds and purchase long-term bonds. This has the effect of driving down long-term rates while modestly boosting short-term rates. Back in 2011, the impact was significant. The 10-year yield went from a high of 3.75% to a low of 1.44%. However, when the Fed stopped the “Twist” and the manipulation was over, the yield spiked back up to 3% quickly.

Bottom line: Home loan rates remain historically low. Fed bond market manipulation may be required should higher inflation cause another increase in rates. Now is a great time to take advantage of rates before we see an even further rise.

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