Monetary Policy Tightening Underway

The first of many expected Federal Reserve hikes of the short-term federal funds rate was announced today. Combined with future balance sheet runoff, these monetary policy moves will lead to higher mortgage rates in 2022 and 2023 as the Fed attempts to curb elevated inflation.

As widely expected by forecasters and markets, the Fed raised the federal funds rate by 25 basis points at the conclusion of its March meeting. There was a single vote for raising by 50 basis points, as inflation readings are near 40-year highs. The “dot plot” of Federal Open Market Committee participants’ future policy expectations indicates 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. We continue to believe, however, that rate hikes for the end of 2022 and 2023 will be data dependent, as the Fed does not want to produce a recession. The economy will undoubtedly slow with this expected path of policy.

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%.

The Fed has upgraded its inflation outlook to a 4.3% year-over-year gain for the PCE measure of inflation. The Fed also reduced its GDP forecast in 2022 to just 2.8%, revealing the difficult task that lies before the central bank as it attempts to reduce inflation while not being too aggressive with respect to monetary policy and producing a recession during the second half of 2022 or 2023. Given the Fed is behind the curve with respect to the build up of inflationary pressures, a so-called soft landing of moderated inflation and ongoing economic growth will be difficult to achieve.

Additionally, the Federal Reserve indicated that balance sheet reduction, after significant asset purchases to produce lower long-term rates, will begin at a future meeting. This will almost certainly start no later than the start of the third quarter of 2022 and produce additional pressure on long-term rates like mortgages.

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 material, 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.