Inflation is a hot topic, whether it is in the press, the gas pump, or at the restaurant.And inflation is now taking priority over weekly and monthly economic news, andis influencing the Federal Reserve’s actions, and also influencing mortgagerates. What should our brokers know about what is happening?

First, brokers should remind their clients that while inflation is currently high, the Fed’s monetary policy works with lags of 12-18 months before the impact of rate changes are fully felt. Thus, the Fed would have had to (among other things) anticipate the severe supply-chain problems we have been experiencing and would have had to start raising rates soon after the initial lockdowns of March/April 2020 to keep current inflation subdued. This is impossible.

Last week we learned that producer prices (which were +0.8% MOM and 9.6% YOY) were well above expectations and the highest reading in 10 years. This adds to pressure on the Fed to act more aggressively despite the market worried about a slow down in growth. Omicron does pose risks to growth over the near term, and inflationmight actually slow early next year as seasonal demand strength gives way to seasonal weakness.

Orion’s brokers should know that, despite rates actually improving last week, the market is fully priced in for a June 2022 Fed Funds and Discount Rate hike, and is implying a 40 percent chance of a March hike, both of which are aggressive as accelerating the taper creates a narrative that the Fed is already responding to the inflation threat, which in turn should help restore its credibility and deflect any future criticism and/or political pressure.

Brokers should also advise their clients that hiking rates in Q1 of 2022 would likely require the Fed to either alter the guidance of "broad-based and inclusive employment," or somehow fudge the definition of maximum employment and convince the public that the goal has been reached. So there is little reason that the Fed would want to lock itself into an earlier tightening path.

The Fed’s balance sheet has almost doubled in the past two years, from $4.5 trillion to $8.5 trillion, and now it owns about 30 percent of all the outstanding mortgage-backed securities. This will shift. The Fed is still buying MBS, just not as much as they used to. Even once they reduce their monthly purchase rate to zero, they will probably still buy enough MBS in the market to compensate for runoff (early payoffs). Traders and investors price mortgage securities as a spread off of risk-free Treasury rates, and MBS spreads have been widening as the market evaluates how much the reduced central bank demand will affect MBS pricing.

So Federal Reserve officials have intensified their battle against the hottest U.S. inflationin a generation by moving to end their asset-buying program earlier and signaling they favor raising interest rates in 2022 at a faster pace than expected. Orion’s management took note that purchases of agency MBS will continue to generally be concentrated in recently produced coupons in 30-yearand 15-year fixed rate agency MBS in the To-Be-Announced market, and will continue to reinvest principal payments from Agency MBS and agency debt in Agency MBS.

Mortgage rates have been kept lower than they otherwise would have been through the Fed’s purchases of longer-term Treasuries and MBS, so forecasts are now that mortgage rates will rise to 4 percent by the end of 2022 and may be more volatile as the Fed backs away from the market. An unfortunate, but necessary, discussion, to have with your clients.

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