You will hear lots of chatter that the Fed raised interest rates in mid-December. But is that true? On December 15th the Governors of the Federal Reserve (The “Fed”) announced that they were beginning to worry that inflation might be taking hold in the U.S. after all. In order to reduce the possibility of inflation remaining high, or going even higher, they announced two actions that should cool the economy and reduce inflationary pressure.
Fed Inflation-Fighting Tools
First, they will begin tapering purchases of mortgage-backed securities (MBSs) and U.S. Treasury Bonds (T-Bills.) They have been buying up to $80 billion (yes, with a “b”) worth of each month ever since the pandemic took hold. This was designed to flush money into the economy to stave off a recession. The strategy worked – we never really dipped into a recession.
Second, the Fed announced that they would raise short term interest rates three times in 2022. It is not true that the Fed raised interest rates, though – yet. If they do as predicted in 2022, however, it will be to cool off the economy to stave off inflation.
What is driving their announcement is that the economy might be a little too hot. Businesses are doing well, but employers are having difficulty finding employees, and inflation (as measured by the Consumer Price Index (CPI) is running higher than we have seen for over 25 years.
Inflation vs Employment
The Fed has long been tasked for decades with a dual purpose – two goals that are at odds with each other: Keep inflation low, and keep employment full by keeping the economy growing (therefore keeping us out of recession.) This is a tough job, since inflation is a consequence of economic growth. Full employment tends to breed inflation, so the two goals conflict with each other.
Therefore, for years they have walked a very fine line making small, incremental moves to keep the economy moving ahead, but not too fast. They do this by using a handful of tools as throttles or brakes to goose or to slow down the economy. They appear to have decided that they have overshot on the growth target this year, and now have to slow down a rapidly expanding economy.
Go deeper: Is Inflation Bad or Good?
Why are we even concerned about inflation? I’m a mortgage advisor, and this is a mortgage blog, so here it is quite relevant. Mortgage rates and inflation are closely related. It’s a complicated relationship, however, and not as direct as some folks think.
For a deeper dive into mortgages and interest rates: The Relationship Between Inflation and Mortgage Rates
Inflation and Mortgage Rates
For years inflation has been running at 2 % or even less. We have seen mortgage rates dip below 2% when it looked like we were going into recession – at which time inflation would presumably be even less than zero. (Inflation turns into deflation.) The last time the Fed raised interest rates was 2016, when the economy seemed to be heating up and unemployment was already extremely low. Inflation remained tame as a result.
In 2020 it seemed that we still had inflation under control. But beginning in 2021 we started seeing increases in reported CPI. For many months the Fed believed inflation to be “transitory,” meaning it would return back down to the 2% range quickly. They may be proven right about that eventually, but for now it appears they were not.
So what happened when the Fed made their announcement on the 15th?
Since mortgage interest rates are long-term rates (meaning that it represents a long-term investment for the investor) then they should respond to expectations of future inflation. (See link to Inflation and Mortgage Rates, above.) If the Fed (presumably the smartest minds in the room) thinks that inflation might be a problem, then rates should have jumped, right?
That’s what all the ads for mortgage companies want you to believe. You have probably already heard ads exhorting you to refinance now, before the Fed actually raises rates and it’s too late. If you haven’t heard them, you will soon.
Interest Rates Move Down
But what actually happened?
Bond yields went down.
What? Take a look at the chart to the right, and you’ll see that the 10-year bond yield was running as high as 1.6750% back in October, but has since been sliding down (albeit a bit unsteadily) in anticipation that maybe inflation would turn out to be transitory after all. The Fed can move the market with just a speech, and for better or worse, they’ve been doing that. On the 15th the yield was 1.4630% in the morning, and by the end of the day had slid to 1.422%. That doesn’t seem like a lot, but note that it’s about 0.250% lower than in October, meaning that investors are willing to take 0.250% less in yield than they were in late October. Did that show up in mortgage rates? Not entirely, but that takes time.
On the 16th bond yields dropped slightly more, and since then have remained pretty stable. Mortgage rates, on the other hand, have stayed up a little, as they almost always do before a holiday.
Future Inflation is the Key
The key take-away is that long-term interest rates are a function of the expectation of future inflation, not measurements of current or past inflation. The Fed announced that because inflation might be an issue moving forward, they were taking steps to curb it. Investors were relieved that they weren’t ignoring inflation, and felt comfortable taking a slightly lower yield.
There was something more important in the deeper message, however. The Fed announced that they were going to reduce the amount of bonds and MBSs that they were buying, not eliminate them entirely, and they announced that they would raise short-term rates in the future, not right away, and even that would depend on then-current readings of the CPI. In other words, they did not announce that the Fed raised interest rates, and aren’t panicked (yet) about inflation. This calmed investors’ fears about future inflation down a bit.
Where Will Mortgages Rates go in 2022?
Moving forward, the direction of mortgage interest rates will depend heavily on future readings of the CPI. What the Fed says or does in response, and what investors think all that means. I think we can say with confidence, however, that if labor prices are driven up substantially, inflation is bound to follow unless competition limits the ability of manufacturers and retailers to raise prices.
We shall see.
Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage (On Amazon)
Mortgage Advisor, Fairway Independent Mortgage
My Blog: www.loanguide.com
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This article represents the opinions of Casey Fleming, and not necessarily those of Fairway Independent Mortgage Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor Fairway Independent Mortgage Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor Fairway Independent Mortgage Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
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