Federal Reserve Raises by 75 Basis Points and Notes Slowing Economy

2022-07-27T18:19:04-05:00

Continuing its tightening of financial conditions to bring the rate of inflation lower, the Federal Reserve’s monetary policy committee raised the federal funds target rate by 75 basis points, increasing that target to an upper bound of 2.5%. This move matches the June rate hike as the largest increase for the funds rate since 1994. While committing to a policy path that will slow demand and reduce inflation pressure, the Fed also, in the first sentence of its July policy statement, acknowledged signs of slowing economic activity (“Recent indicators of spending and production have softened.”). Among the clear signs of this slowing are just about every housing indicator, including seven straight months of declines for home builder sentiment. Indeed, an open macro question is whether the economy experienced a recession during the first half of 2022. GDP data for the second quarter published tomorrow will provide additional evidence (although a rising unemployment rate remains missing for the NBER call). However, given declines for single-family permits, single-family starts, pending home sales, and rising sales cancellations rates, it is clear a housing industry recession is ongoing. Market participants have reduced their expectations for future Fed rate hikes, which is perhaps a sign of renewed confidence in the ability of the Fed to bring inflation down (even if it means a recession in the so-called hard landing scenario). Higher interest rates and lower economic growth will eventually bring inflation rates down. The path of required additional tightening will depend on economic growth and inflation data, moving the Fed to a more data dependent stance. Thus, the chance of the Fed decelerating to a 50 basis point hike in September is increasing. It is important to note that there is not a direct connection between federal fund rate hikes and changes in long-term interest rates. During the last tightening cycle, the federal funds target rate increased from November 2015 (with a top rate of just 0.25%) to November 2018 (2.5%), a 225 basis point expansion. However, during this time mortgage interest rates increased by a proportionately smaller amount, rising from approximately 3.9% to just under 4.9%. Moreover, the spread between the 30-year fixed rate mortgage and the 10-year Treasury rate has expanded to more than 270 basis points as of this week. Before 2020, this spread averaged a little more than 170 basis points. This elevated spread is a function of MBS bond sales as well as uncertainty related to housing market uncertainty. While the 10-year rate has flattened in recent weeks on growth concerns, a reduction in this spread would be a positive sign for mortgage rates and housing demand. Finally, the Fed has previously noted that inflation is elevated due to “supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” While this verbiage may incorporate policy failures that have affected aggregate supply and demand, the Fed should explicitly acknowledge the role fiscal, trade and regulatory policy is having on the economy and inflation as well. Related ‹ Share of New Home Sales Backed by FHA Loans Reaches 14-Year LowTags: economics, FOMC, home building, housing, interest rates

Federal Reserve Raises by 75 Basis Points and Notes Slowing Economy2022-07-27T18:19:04-05:00

Federal Reserve Accelerates Rate Hikes

2022-06-15T14:15:41-05:00

To fight persistent inflation, the Federal Reserve has committed to significantly cooling demand. This approach reflects a non-monetary policy failure to fix underlying supply-side challenges that are pushing up inflation. The Fed lacks policy tools to make these supply-side fixes, so it must rely on demand-side impacts to bring down inflation by reducing economic growth. Consequently, at the conclusion of its June meeting, the Fed raised the federal funds target rate by 75 basis points, increasing that target to an upper bound of 1.75%. This is the largest increase for the funds rate since 1994 and is a clear response to elevated inflation data from May. Moreover, the Fed’s forward-looking projections indicate on a median participant basis an additional 205 basis points of tightening through 2023. Without convincing evidence of moderating inflation, the Fed is likely to continue to raise the target rate at each meeting by 50 basis points or more. The Fed’s target is a 2% inflation rate. The Fed’s June statement also confirmed its existing plan to reduce its balance sheet, including net reduction of $35 billion of mortgage-backed securities a month when fully phased in. The lack of change for the balance sheet reduction plan is a positive element of today’s news for housing, as there was a risk of a planned faster pace, which would further increase mortgage interest rates. Given signs of slowing economic activity, including six straight months of declines for home builder sentiment, a clear risk is that by falling behind the curve, the Fed will overshoot on tightening and bring on a recession as it fights inflation. This would not be the soft landing the Fed is attempting to orchestrate. Indeed, the NAHB economic forecast now includes a 2023 recession as financial conditions tighten. Chair Powell noted in his press conference that housing market conditions are slowing given higher mortgage rates. The Fed notes that inflation remains elevated, citing the Ukraine war and global supply-chain issues, among other factors. Their revised economic projections find slowing economic growth, with a GDP outlook for 2023 of 1.7%. This will be very difficult to achieve. The Fed’s unemployment projection sees that rate increasing to 4.1% through 2024.  So even under this optimistic outlook, this increase for joblessness would qualify as a growth recession. As this economic slowing occurs, the Fed’s projections indicates inflation will decline. Using the core PCE measure, the Fed sees a 4.3% rate for 2022, then 2.7% in 2023 and falling to 2.3% in 2024. This too will be difficult to achieve given the lagged impact on inflation from increasing residential rents, which materialize in inflation readings on a lagged basis when leases are renewed. This shelter impact on inflation is also a reminder that tightening interest rate conditions can affect supply, not just demand. Higher rents are due to a lack of housing supply. And higher interest rates will make it difficult to finance the development of additional housing supply. It is important to note that there is not a direct connection between federal fund rate hikes and changes in long-term interest rates. During the last tightening cycle, the federal funds target rate increased from November 2015 (with a top rate of just 0.25%) to November 2018 (2.5%), a 225 basis point expansion. However, during this time mortgage interest rates increased by a proportionately smaller amount, rising from approximately 3.9% to just under 4.9%. Previously, the Fed noted that inflation is elevated due to “supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” While this verbiage may incorporate policy failures that have affected aggregate supply and demand, I do think the Fed should explicitly acknowledge the role fiscal, trade and regulatory policy is having on the economy and inflation as well. Given today’s projections, we reiterate our policy recommendation with respect to any possibility of a soft landing. Clearly, elevated inflation readings call for a normalization of monetary policy, particularly as the economy moves beyond covid-related impacts. However, fiscal and regulatory must complement monetary policy as part of this adjustment. Yet, many of these measures are simply beyond the Fed’s control. For example, higher inflation in housing is due to a lack of rental and for-sale inventory and cost growth for building materials, lots and labor. Higher interest rates will not produce more lumber. A smaller balance sheet will not increase the production of appliances and materials. In short, while the Fed can cool the demand-side of the economy (reducing inflation and growth), additional output on the supply-side is required in order to tame the growth in costs that we see in housing and other sectors of the economy. And efficient regulatory policy in particular can help achieve this goal and fight inflation. Related ‹ Weakening Builder Confidence Points to Economic Troubles AheadTags: economics, FOMC, home building, housing, inflation, interest rates, single-family

Federal Reserve Accelerates Rate Hikes2022-06-15T14:15:41-05:00

The Fed Commits to Aggressive Tightening of Monetary Policy

2022-05-04T15:17:22-05:00

Following a 25 basis points increase in March, the Federal Reserve’s monetary policy committee unanimously approved a further 50 basis points increase for the federal funds target rate, the largest increase for the rate in more than two decades. The Fed also provided details for its plan to reduce its balance sheet (quantitative tightening), which will further tighten financial conditions. Taken together, these monetary policy moves will produce higher mortgage rates in 2022 and 2023 as the Fed attempts to curb elevated inflation. However, today’s announcement matched market expectations, with some impacts already incorporated in bond rates and prices. Today’s moves were not more hawkish than expected. Forecasters and the Fed’s own projections suggest an ongoing series of aggressive rate hikes as 2022 progresses. The prior March “dot plot” of Federal Open Market Committee participants’ future policy expectations indicated a median outlook of seven 25 basis point increases in 2022, one at each future meeting, plus an additional three 25 basis points of tightening in 2023. Many forecasters see a more aggressive pace, with some suggesting the Fed could increase by 75 basis points in June. However, Chair Powell appeared to rule that option out during his press remarks, while confirming additional 50 basis points hikes are ahead. We continue to believe, however, that rate hikes for the end of 2022 and 2023 will be data dependent, as the Fed wants to avoid a recession while tackling inflation. The economy will undoubtedly slow with this expected path of policy. Higher interest rates are also reducing housing affordability and pricing prospective buyers out of an already tight property market. It is also important to note that there is not a direct connection between federal fund rate hikes and changes in long-term interest rates. Indeed, during the last tightening cycle, the federal funds target rate increased from November 2015 (with a top rate of just 0.25%) to November 2018 (2.5%), a 225 basis point expansion. However, during this time mortgage interest rates increased by a proportionately smaller amount, rising from approximately 3.9% to just under 4.9%. This week’s Fed announcement also provided details on the its plan for balance sheet reduction. In a phased approach, the Fed will allow a capped level of proceeds from maturing bonds to roll off on a monthly basis. This allows for a partial reduction of assets held by the Fed. Starting in June, the plan will involve a reduction of $30 billion of Treasury securities and $17.5 billion of mortgage-backed securities (MBS). After three months, the monthly cap for Treasury bonds will increase to $60 billion and $35 billion for MBS. Balance sheet reduction has a larger proportional effect on long-term rates, like mortgages. However, this plan matches prior market expectations, so some of the expected market impact is already priced in rates. The Fed noted that inflation is elevated due to “supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” While this verbiage may incorporate policy failures that have affected aggregate supply and demand, I do think the Fed should acknowledge the role fiscal, trade and regulatory policy is having on the economy and inflation as well. Given this expected path of monetary policy, we reiterate our policy recommendation with respect to a soft landing. Clearly, elevated inflation readings call for a normalization of monetary policy, particularly as the economy moves beyond covid-related impacts. However, fiscal and regulatory must complement monetary policy as part of this adjustment. Higher inflation in housing is due to a lack of rental and for-sale inventory and cost growth for building materials, lots and labor. Higher interest rates will not produce more lumber. A smaller balance sheet will not increase the production of appliances and materials. In short, while the Fed can cool the demand-side of the economy, additional output on the supply-side is required in order to tame the growth in costs that we see in housing and other sectors of the economy. And efficient regulatory policy in particular can help achieve this goal and fight inflation. Related ‹ Slight Rise for Construction Job OpeningsTags: economics, FOMC, home building, housing

The Fed Commits to Aggressive Tightening of Monetary Policy2022-05-04T15:17:22-05:00

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