The Federal Reserve raising short-term interest rates by 0.5% was anticipated. Of much more interest to market participants was how the Fed planned to handle running down its investments made in the aftermath of the pandemic.
What you might find interesting is that mortgage pricing has actually gotten better in the aftermath of the announcement. If you’re in the market to buy a home or refinance, it’s a great day to lock your rate.
We break down exactly what happened. Our analysis is in bold.
Although overall economic activity edged down in the first quarter, household spending and business fixed investment remained strong. Job gains have been robust in recent months, and the unemployment rate has declined substantially. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.
Although gross domestic product (GDP), the primary measure of economic growth – or lack thereof – actually declined in the first quarter, the Fed seems to be taking this shrinking of the economy in stride. It’s been primarily blamed on starting from an incredibly high point in the fourth quarter.
Very high inventories along with lots of imports relative to what we export were largely responsible for bringing down the number. However, high imports and decreasing inventory relative to what it had been means that Americans are buying plenty, which ultimately is a good sign.
Beyond that, many other economic metrics seem to be in good shape. Importantly, household spending looks good to the Fed, along with business investment, while the unemployment rate can’t get much lower.
The key thing the Fed is focused on changing at the moment is the level of inflation. There’s been an ongoing supply and demand imbalance since Americans started spending again after the initial shock of the pandemic, but recent spikes in energy prices and generalized price upticks across the economy have the Fed’s eye.
The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the U.S. economy are highly uncertain. The invasion and related events are creating additional upward pressure on inflation and are likely to weigh on economic activity. In addition, COVID-related lockdowns in China are likely to exacerbate supply chain disruptions. The Committee is highly attentive to inflation risks.
In addition to the human toll caused by Russia’s invasion of Ukraine that can’t be understated, it’s also thrown the global economy for a bit of a loop. Russia is a major oil producer. While sanctions on the country and boycotts of its oil certainly punish Russia, that also means we have to find other sources. While efforts have been made to mitigate some of this, it has meant higher prices at the pump.
Meanwhile, COVID-19-related lockdowns are again happening in parts of China. Because so much is made and exported from there, there is a worry that this could exacerbate existing supply chain issues. Between the ongoing oil and Chinese supply concerns, these create further inflation risks.
The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong. In support of these goals, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent and anticipates that ongoing increases in the target range will be appropriate. In addition, the Committee decided to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities on June 1, as described in the Plans for Reducing the Size of the Federal Reserve’s Balance Sheet that were issued in conjunction with this statement.
There are two key things that investors were looking at heading into this meeting: how much the Federal Reserve would move the federal funds rate and its plan for getting some pandemic-era investments off its books.
Starting with the federal funds rate, the Fed raised its target range by 0.5% to 0.75% – 1%. The fed funds rate is the rate at which federally insured banks borrow money from each other overnight to meet their obligations. Although this is a short-term rate, this cost tends to get passed through to consumers in the form of higher borrowing costs across a lender’s entire portfolio.
In other words, although the federal funds rate isn’t directly correlated with mortgage rates, they tend to follow the same general direction. It’s important to note that mortgage pricing has actually dropped in the immediate aftermath of the announcement because this level of rate increase was anticipated already.
Higher interest rates mean that borrowing becomes relatively more expensive. When that happens, people are more likely to hold onto the money and enjoy higher savings account interest rates rather than continuing to borrow and spend more. Less money going through the economy would tap the brakes on inflation. On the other hand, it can also slow economic growth, so the Fed has a major balancing act.
The other big portion of the announcement the investors had their eye on was how the Federal Reserve would handle getting assets like Treasuries and mortgage-backed securities (MBS) off its balance sheet. We’ll focus for the next couple of paragraphs on the MBS piece of this.
MBS underlie mortgage rates. They’re sold in the bond market and are considered some of the safest investments because most have either an actual or implied government guarantee. However, safe investments often mean a lower rate of return compared to the risk/reward scene if you invest in stocks.
Realizing housing is a major part of the U.S. economy, the Federal Reserve stepped in at the beginning of the pandemic to buy mortgage bonds in high levels and keep rates low, encouraging residential investment. The Fed currently holds more than $2.7 trillion worth of mortgage bonds.
It wants to start selling these off for a couple of reasons: First, it would give the Fed room to do this again in response to a future economic crisis. However, the second potentially bigger reason at this point is that housing prices are increasing at extremely fast levels. In the past year, the Case-Shiller Home Price Index is up more than 20%. This is no doubt contributing to overall inflation.
High levels of home price appreciation year-over-year are likely being supported by the low interest rates, which have been supported by the Fed. Investors who buy mortgage bonds from this point forward are very likely to demand a higher rate of return than the Fed. That’s going to push up interest rates.
Beginning June 1, the Fed plans to sell $17.5 billion worth of mortgage bonds per month. After 3 months, that number will increase to $35 billion per month. If you’re ready to get a mortgage, the sooner you lock your rate, the better.
In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook. The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals. The Committee’s assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.
The Committee looks at a variety of factors in assessing the overall health of the economy. Most of the major concerns center around inflation at the moment, though.
Voting for the monetary policy action were Jerome H. Powell, Chair; John C. Williams, Vice Chair; Michelle W. Bowman; Lael Brainard; James Bullard; Esther L. George; Patrick Harker; Loretta J. Mester; and Christopher J. Waller. Patrick Harker voted as an alternate member at this meeting.
Committee members were in agreement.
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