Higher Interest Rates Stick Around

Ivanna Hampton: Higher interest rates are sticking around for longer. While Fed Chair Jerome Powell didn’t seem worried about the inflation outlook, he seemed to make it clear that rate cuts will have to wait. So, what should investors expect? Preston Caldwell is a senior US economist for Morningstar Research Services.

Thanks for being here, Preston.

Preston Caldwell: Thanks for having me, Ivanna.

Hampton: Before getting into Powell’s press conference, let’s talk about why inflation increased in the first quarter.

Caldwell: So just going back, in the second half of 2023, we saw inflation running at about a 2% rate, right back to the Fed’s 2% target. But then in the first quarter, core PCE inflation, which is the Fed’s preferred measure, accelerated to 3.7% quarter-over-quarter annualized. That was driven partly by an uptick in durable goods inflation, as well as financial-services inflation. And also housing inflation, it didn’t increase, but it didn’t demonstrate the reduction that was anticipated by many investors. So those all caused inflation to jump to a new high in the first quarter, or the highest level in about a year. And that essentially has dashed market expectations of rate cuts happening in early 2024. If we go back to the beginning of 2024, market participants had expected rate cuts to happen as soon as March of this year. And now they’re not expecting them to happen until September. Now, our view is that the drivers of the inflationary uptick in the first quarter are unlikely to repeat over the rest of the year. And so, we should see inflation to resume its progress back to the Fed’s 2% target over the rest of this year and beyond.

Hampton: Now, Powell says the data has not given the Fed greater confidence. Has the clock reset on plans to cut interest rates?

Caldwell: Interest-rate cuts are still very much in the cards, more than anything because rates are at currently restrictive levels. The federal-funds rate is in a target range of 5.25% to 5.50%, which is much above the kind of 2% to 3% range of interest rates that the Fed would expect to prevail in normal times. So, if we do get inflation back to 2%, which should happen by our expectations and by the Fed’s expectations with rates being where they’re at, then hitting the Fed’s inflation target will call for lowering the federal-funds rate quite steeply. And then, of course, if we see weakness in terms of economic activity or the job market, then that would just add further reason to bring interest rates down. So, we’re actually ultimately expecting the federal-funds rate to fall still to a target range of 1.75% to 2.00% by year-end 2026. Now, that is a long time frame. So, we’re still looking at a period where interest rates will likely remain high for the time being, with the first federal-funds rate cut not coming probably now until September of 2024.

Hampton: Now, while rates were left unchanged, the Fed did announce a change to its policy for reducing its bond holdings, otherwise known as quantitative tightening. What do investors need to know?

Caldwell: This was something that the Fed had discussed earlier, but then markets had thought that perhaps the Fed would put these plans on hold given the inflationary uptick and the delay in rate cuts, but the Fed decided to go ahead and proceed with this which was—right now, the Fed is selling off its long-term asset portfolio. The rate of a balance-sheet runoff is capped at about $95 billion per month. That cap is being reduced to $60 billion per month in combined Treasury and other security sales. So, basically, a very large reduction in the rate of those asset sales, which the fact that the Fed will sell fewer of those assets going forward is helping to support asset prices. In other words, long-term Treasury yields have dropped somewhat, I think based off that news. We see the 10-year Treasury yield was down about 5 basis points today, and that probably reflect the reduced pace of asset sales announced by the Fed.

Hampton: And talk about how higher-for-longer interest rates affect people with credit card debt or shopping for mortgages.

Caldwell: The fact that the Fed is postponing rate cuts and just the prospects that wherever rates ultimately settle back down at could be higher than previously anticipated has altogether combined to drive the 10-year Treasury yield up from about 4% at the beginning of this year to 4.6% as of today. That 10-year Treasury yield means higher borrowing rates for any longer-term fixed-rate borrowers. That’s meant higher mortgage rates. Now credit card debt tends to be tied to short-term interest rates, so not so much affected, although insofar as the federal-funds rate remains high, then credit card borrowers are continuing to—and other short-term rate borrowers are continuing to—pay very high rates. But really, I mean, mortgage rates are probably the area where people see the biggest impact, where there’s a huge increase in the monthly payment that you’re going to incur taking out a 30-year mortgage.

I think most homebuyers right now are really buying on the promise and hope that they can refinance a few years down the line, and that’s contingent on the Fed cutting rates quite aggressively, actually. If you’re going to achieve a 30-year mortgage rate below 5%, let’s say, not to mention the 3% to 4% that we had just a few years ago and was prevailing prior to the pandemic, the Fed is actually going to have to cut even more than markets are anticipating right now. So that’s a big reason why we think the Fed will ultimately cut more than markets expect is because we think much lower mortgage rates are going to be needed to drive a sustained recovery in the housing market, because at some point, homebuyers are going to lose hope that they’ll be able to refinance down the line, and they’re just not going to put up with these high mortgage rates for any longer.

Hampton: Preston, thank you for your insights today.

Caldwell: Thanks for having me, Ivanna.