An End to Large Rate Hikes from the Fed?

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 4%. This marks the fourth consecutive meeting with an increase of 75 basis points and pushes the fed funds rate to a 15-year high. These supersized hikes were intended to move monetary policy more rapidly to restrictive policy rates. The Fed’s leadership has previously signaled they intend to hold these restrictive rates for a substantial period time, perhaps into 2024.

Importantly, the November policy statement also contained hints of a pivot to a slower rate of hikes in the future. While noting that additional rate increases are required to bring inflation down to the Fed’s 2% target (with a higher than previously expected top rate), new messaging in the statement suggests a slowing of the size of the rate hikes. The Fed “will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

This verbiage indicates the Fed will adjust its future actions based on expected lags with respect to already implemented tightening and will respond to additional signs of a slowing economy. This is a more data dependent and less forecast dependent policy outlook. In general, this policy adjustment is a positive development for housing because the current risk for Fed policy is of tightening too much and bringing on a more severe recession or a financial crisis.

The Fed noted that economic activity is experiencing “modest growth.” Adding detail to this, in his press conference Chair Powell appropriately indicated the economy has “slowed significantly from last year’s rapid pace” and the housing market has “weakened significantly largely reflecting higher mortgage rates.” Powell also noted that tightening financial conditions are having negative impacts on the most interest rate sensitive sectors, specifically citing housing. Powell noted that the “housing market needs to get back into a balance of supply and demand.” Of course, the best way to do this is for policymakers to reduce the cost of constructing new single-family and multifamily housing.

The Fed also sees labor market softening, with their projections from last month forecasting that the unemployment rate will increase to 4.4% in 2023. This is an optimistic forecast; NAHB projects a rate near 5% at the start of 2024.

In September, the Fed’s “dot plot” indicated that the central bank expects the target for the federal funds rate would increase by 75 more basis points in November, and then 50 in December and concluding with 25 points at the start of 2023. This would take the federal funds top rate to near 4.8%. Today’s messaging from the Fed suggests that they are considering a higher terminal rate, perhaps above 5%. Powell also noted that the Fed needs to see a decisive set of data of slowing inflation to judge the appropriate level for the top fed funds rate. However, Powell refused to commit that the Fed is now biased against another 75 basis point increase.

Combined with quantitative tightening from balance sheet reduction (in particular $35 billion of mortgage-backed securities (MBS) per month), the combination of past moves and expected, additional rate hikes represents a significant amount of monetary policy tightening over a short period of time. Given this intended policy stance, a hard landing with a mild economic recession is, in our view, highly likely. However, by 2025, the Fed is forecasting a return to a normalized rate of 2.5% for the federal funds rate.

Among the clear signs of economic slowing are just about every housing indicator, including ten 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, during which the economy posted two quarters of GDP declines. The missing element from the recession call: a rising unemployment rate, which is coming. Regardless, 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, with eventual large spillover impacts for the overall economy.

In the meantime, housing’s shelter inflation readings have remained hot. Within the September CPI data, owners’ equivalent rent was up 6.7% compared to a year ago. In fact, over the last three months, this measure was increasing at an annualized rate of 8.9%. Rent was up 7.2% compared to a year ago.

Housing is also central to the risk of the Fed raising rates too high for too long. Regardless of Fed actions, elevated CPI readings of shelter inflation will continue going forward because paid rents will take time to catch-up with prevailing market rents as renters renew existing leases. This lag means that CPI will show inflationary gains months after prevailing market rent growth has in fact cooled. The core PCE measure, the growth rate of which peaked in early 2022, is better indicator of inflation and suggests the current Fed outlook may now be entering too hawkish territory.

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%. The 30-year fixed mortgage rate, per Freddie Mac, is near 7% today but will move higher in the months ahead.

Moreover, the spread between the 30-year fixed rate mortgage and the 10-year Treasury rate has expanded to approximately 300 basis points as of last 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 risks.

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.

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