Two opposing forces influenced mortgage markets this week. Lower than expected inflation data was very welcome news to investors, but an aggressive tone from the Fed was not. The net effect was that mortgage rates ended the week nearly unchanged.
The Consumer Price Index (CPI) is a closely watched inflation indicator that looks at price changes for a broad range of goods and services. In July, CPI was 8.5% higher than a year ago, below the consensus forecast, and down sharply from 9.1% last month. Core CPI excludes the volatile food and energy components and provides a clearer picture of the longer-term trend. Core CPI in July was 5.9% higher than a year ago, also below the consensus forecast, and down from a peak of 6.5% in March, the highest annual rate of increase since 1982.
Looking below the surface, apparel prices, used vehicle prices, and airline fares posted declines in July. Housing costs, which represent roughly 40% of core CPI, continued to climb significantly, but they tend to reflect changing market conditions more slowly than the other items in the index. In other words, current housing costs often take a couple of extra months to pass through to the report due to measurement issues. This lag is one primary reason that Fed officials place more weight on a different inflation report, the PCE price index, which comes out later in the month.
While the inflation news was better than expected in July, the annual rate of Core CPI remained far above the readings around 2.0% seen early in 2021, which is the stated target level of the Fed. Due to this, recent comments from Fed officials have indicated that they do not agree with the investor outlook for monetary policy next year. Officials and investors both anticipate additional rate hikes at the next few meetings which will increase the federal funds rate to around 3.50% by the end of the year. At that point, Fed officials expect to either hold rates steady or raise them even more based on economic conditions. However, investors have priced in rate cuts next year on the theory that a slowing economy will cause the Fed to shift back to supporting growth over fighting inflation. Since looser monetary policy is generally better for mortgage markets, these recent comments predicting a tighter path were unfavorable for mortgage rates.
Investors will watch for additional Fed guidance on the pace of future rate hikes and bond portfolio reduction. Beyond that, Housing Starts will come out on Tuesday. Retail Sales will be released on Wednesday. Since consumer spending accounts for over two-thirds of U.S. economic activity, the retail sales data is a key indicator of the health of the economy. Existing Home Sales will come out on Thursday.