Overview: Although Federal Reserve officials have become increasingly hawkish (in favor of tighter monetary policy) in recent weeks, their plans for reducing the Fed’s massive bond portfolio exceeded even the elevated investor expectations seen a week ago. This had a negative impact on mortgage markets, and rates ended at the highest levels since late 2018.
To help support the economy during the pandemic, the Fed put in place extremely accommodative policy measures, including a new bond-buying program. The massive purchases of Treasuries and mortgage-backed securities (MBS) over the last couple of years more than doubled the size of the Fed’s balance sheet to roughly nine trillion dollars. This added demand for MBS helped push mortgage rates to record lows. With the economy on stronger footing and a very tight labor market, the Fed now must reverse these loose policies to fight skyrocketing inflation.
The minutes from the March 16 Fed meeting released on Wednesday revealed the details of the Fed’s plans for balance sheet reduction. The Fed will allow its holdings of Treasuries and MBS to decrease by up to $95 billion per month, which was much higher than had been anticipated just days earlier. The split will be $60 billion in Treasuries and $35 billion in MBS, phased in over three months, likely beginning in May. Since mortgage rates are largely based on MBS prices, the prospect of reduced future demand caused rates to rise.
The closely watched monthly Employment Report released on Friday came in very close to the expected levels. The economy gained 431,000 jobs in February, a little below the consensus forecast of 475,000, but revisions added 95,000 to the results from prior months. The unemployment rate fell from 3.8% to 3.6%, the lowest level since early 2020. Average hourly earnings were a solid 5.6% higher than a year ago, up from an annual rate of 5.2% last month, helping workers deal with rising prices.
The Personal Consumption Expenditures (PCE) Price Index is the inflation indicator favored by the Fed. In February, core PCE was 5.4% higher than a year ago, up from 5.2% last month and the highest annual rate since 1983. For comparison, readings were below 2% during the first three months of 2021. One of the big questions for investors is how quickly inflation will moderate as pandemic-related disruptions are resolved.
Unemployment Rate (%)
Looking ahead, investors will closely monitor news about Ukraine and will look for additional guidance from Fed officials on the timing for future rate hikes and balance sheet reduction. Beyond that, the Consumer Price Index (CPI) will be released on April 12. CPI is a widely followed monthly inflation indicator that looks at the price changes for a broad range of goods and services. The Retail Sales report will come out on April 14. Since consumer spending accounts for over two-thirds of U.S. economic activity, the retail sales data is a key indicator of growth.