The Fed Takes Action

May 6, 2022

Last Week in Review: The Fed Takes Action

This past week, the Federal Reserve hiked the Fed Fund Rate by .50%, the largest rate increase in 22 years. Let’s discuss what other action the Fed took, how the market reacted and what to look for in the week ahead.

“I would like to first speak to the American people. Inflation is much too high, and the Fed understands the hardship and is moving expeditiously to bring down inflation.” Fed Chair Jerome Powell – May 4, 2022.

How does the Fed move to bring down inflation? Raise rates and tighten monetary conditions. And this started last Wednesday when the Fed raised the Fed Funds rate by .50%. In a separate measure, the Fed will also begin shrinking its enormous $9T balance sheet of Treasuries and mortgage-backed securities (MBS).

It is important to remember that this hike in Fed Funds Rate has no direct effect on home loan rates. Oddly enough, the measures the Fed is taking to lower inflation help preserve the value of long-term bonds like MBS. If the Fed is successful in bringing down inflation, it will help long-term bond prices improve and long-term rates remain relatively stable.

The lift to the Fed Funds Rate will immediately impact all short-term loans, like auto loans, credit card debt, and home equity lines of credit. Increasing these rates is expected to slow consumer demand, which in effect will slow price increases.

Powell gave the market comfort when he said there was “a good chance to have a soft landing”. Meaning the Fed can continue to raise rates more and slow demand without pushing the economy into a recession.

How much more will the Fed hike rates? The Fed Chair signaled they are likely to raise rates by another .50% in both June and July. Of course, making these moves will depend on the incoming data. This means we should continue to expect high-interest rate volatility around key economic reports like inflation, GDP, and the labor market.

“Beginning on June 1, principal payments from securities held in the System Open Market Account will be reinvested to the extent that they exceed monthly caps.” FOMC announcement on balance sheet reduction.

The balance sheet reduction announcement means the Fed will be buying fewer bonds going forward. This is the opposite of what the Fed did through Quantitative Easing where they purchased $120B worth of Treasuries and MBS every month. It is not yet truly clear what will happen to home loan rates once the process in June commences as the Federal Reserve has only once shrunk the balance sheet for a limited amount of time back in 2018.

“It’s a strong economy and nothing about it suggests it’s close to or vulnerable to a recession. We have a good chance to restore price stability (lower inflation) without a recession”. Jerome Powell.

These words initially provided some comfort to both stocks and rates, but come Thursday, after sleeping on it, interest rates crept higher with MBS prices hitting 11-year lows and the 10-yr Note yield touching 3.09%.

Despite the Fed Chair saying the Fed is not considering a .75% rate hike, the markets finished the week assigning a very high probability the Fed will hike by .75% in June.

Bottom line: Home loan rates are at an important juncture. While MBS attempt to stabilize, there is a real threat they can go another leg higher and fast. If you are considering a purchase transaction, now is the time to lock.

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