If rates are at their lowest in 4 months, why is the Fed saying they are going up?

Mortgage rates have officially hit a 4-month low after inflation data this week. Despite the recent progress, Fed officials continue to talk about keeping interest rates high “for as long as possible.” Who is telling the truth?

First, we know that mortgage rates are at a 4-month low because this assertion is based on the past rather than the future. You’ll have to go back to September 12th to see anything less for the average lender. We also know that inflation has been the driving force behind the massive interest rate volatility we’ve seen over the past 12 months.

Specifically, the Consumer Price Index (CPI) has been at the crime scene for most of the largest rate moves. Until November, all but one of these big moves were toward higher rates, but things have changed since then.

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Rates respond to inflation data because rates are based on bonds and inflation directly affects bond yields. They responded more than usual last year because inflation jumped at the fastest pace in 40 years in 2022. Recent reports show progress on the inflation front, so long-term rates like mortgages show some hope for the future.

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All of the above makes sense from a commonsense standpoint, so why do Fed officials keep saying that more rate hikes are needed and that rates will stay high for as long as possible?

One source of confusion is the fact that the federal funds rate (the thing the Fed raises/lowers/etc) is different from mortgage rates. The federal funds rate applies to overnight lending between large institutions and has the greatest impact on short-term bonds. The longer the bond, the more different it will be from the Fed rate.

The Fed sees the ceiling possibly rebounding in inflation and thinks, “Great, but let’s not get complacent. We have to get inflation back into the 2% range.”

The Fed is coaxing inflation down by keeping short-term interest rates high. This impedes the flow of credit through the financial market, and ultimately slows economic demand enough to force sellers to lower prices. That’s the simple idea anyway.

While some might argue that the Fed has already risen enough that inflation will certainly continue to fall, the Fed is wary of repeating a mistake from the 1980s when it cut interest rates too soon and inflation erupted again. They are particularly sensitive to these risks because of the still very strong job market.

In other words, the Fed has to stick to a tough anti-inflationary text or risk the market getting too squeamish when considering potential rate cuts. Such exuberance could undo some of the progress against inflation that has been made recently.

Despite the Fed’s blunt talk, they are beginning to acknowledge that it is time to slow down the pace of rate hikes. At this point, the market just sees the Fed being able to go up two more times and by a smaller amount than last time. Once the Fed stops walking so far, they are united in their goal of keeping rates high for as long as possible.

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It is impossible to know how long it will take “as long as possible”. What we do know is that the rate path will take cues from inflation and employment data. If inflation continues to fall and unemployment rises, the market will increasingly bet on the Federal Reserve cutting interest rates. Right now, with inflation just beginning to confirm a turnaround and unemployment still very low, it’s no surprise to see price expectations settling into a narrower, broader pattern.

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The bright side is the fact that long-term interest rates often start to fall long before the Fed when it comes to these rise/cut cycles. The chart below shows how that has played out with the 10-year Treasury yields (closely correlated with mortgage rates) and the federal funds rate more recently.

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We won’t know if the Fed will reduce the size of its next rate hike until February 1st. Every now and then, markets will pay close attention to economic data, looking for any evidence of a pickup in inflation or an acceleration in wage growth. The data available over the next three weeks is not quite in the same league as the data for the past two weeks, so markets may not move with much conviction until the hearing from the Fed.

The bond market and most mortgage lenders will be closed on Monday due to the Martin Luther King Jr. holiday

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