As expected, the Fed hiked its benchmark Fed Funds Rate by 50 basis points at its meeting last Wednesday. This was the Fed’s seventh rate hike of the year though it was a slower pace after four consecutive 75 basis point hikes at their meetings in June, July, September and November. The Fed Funds Rate is the interest rate for overnight borrowing for banks and it is not the same as mortgage rates. When the Fed hikes the Fed Funds Rate, they are trying to slow the economy and curb inflation.

What’s the bottom line? In their statement after the meeting, the Fed said that ongoing increases to the Fed Funds Rate would be appropriate and that they would continue their balance sheet reduction. The surprise was in the Fed Funds Rate outlook, where 17 of 19 members forecasted a Fed Funds Rate of over 5%. The projected terminal rate, or the highest the Fed Funds Rate will go in the cycle, increased by 50 basis points to 5.1% from 4.6%. 

While the markets initially reacted negatively to this news because it signaled that the Fed intended to keep rates higher for longer than anticipated, sentiment shifted during Fed Chair Jerome Powell's press conference. He acknowledged that, “The inflation data received so far for October and November show a welcome reduction in the monthly pace of price increases." 

Powell went on to telegraph a 25 basis point hike at the Fed’s next meeting on February 1. This continual slowing in the pace of hikes was considered a positive sign, as it signaled to the markets that inflation is getting under control.

Consumer Inflation Cooler Than Expected Last Month

The Consumer Price Index (CPI), which measures inflation on the consumer level, showed that inflation increased by 0.1% in November, coming in lower than estimates. On an annual basis, inflation declined from 7.7% to 7.1%, which was much cooler than the 7.3% expected. Core CPI, which strips out volatile food and energy prices, also came in softer than forecasted with a 0.2% rise. As a result, year-over-year Core CPI decreased from 6.3% to 6%, which again was lower than estimates.

Of particular note, shelter costs make up 39% of Core CPI and they rose 0.6% in November, meaning they played a big role in the 0.2% monthly gain in Core CPI. However, shelter costs have been lagging in the CPI report.

In more real-time data, we are seeing a moderation in rental prices. For example, Apartment List’s National Rent Report showed that rents were up 4.7% from January through November of this year, well below the 18% rise reported this time last year. These moderating shelter costs should be reflected in the CPI data hopefully by January, which should add additional downside pressure to inflation. 

What’s the bottom line? Inflation is the arch enemy of fixed investments like Mortgage Bonds because it erodes the buying power of a Bond's fixed rate of return. If inflation is rising, investors demand a rate of return to combat the faster pace of erosion due to inflation, causing interest rates to rise as we’ve seen this year.

When we look at how inflation is calculated, there is hope that it will continue to move lower next year. CPI is a rolling twelve-month report. If we add the previous 12 monthly readings and account for rounding and compounding, we come up with the year-over-year figure. For example, when the data for November 2022 was released last week (0.2% for Core CPI), it replaced the data for November 2021 (0.5%) in the calculation of annual inflation.

Going forward, the inflation readings that will be replaced are high, so if we see lower monthly readings like we did in November’s report, the annual rate of inflation will continue to move lower. Again, lower inflation typically helps both Mortgage Bonds and mortgage rates improve.