Officials see no reason to rush rate cuts or ease up on mortgage bond reductions
Federal Reserve officials are signaling caution but not alarm as long-term inflation expectations creep higher, even as they take measured steps to slow balance sheet reduction — a move that supports market liquidity, though mortgage rates may not feel the benefit just yet.
On Friday, New York Fed President John Williams and Chicago Fed President Austan Goolsbee echoed comments from Chair Jerome Powell, who earlier in the week brushed aside recent concerns about inflation expectations becoming unanchored.
“There are no signs of inflation expectations becoming unmoored relative to the pre-pandemic period,” Williams said at a conference in Nassau, Bahamas.
That message comes in response to a closely watched University of Michigan survey showing consumer expectations for inflation over the next five to 10 years have risen for three straight months, now sitting at 3.9% — the highest level in over 30 years.
The uptick has spooked some investors, who fear a resurgence in inflation tied to the Trump administration’s trade policies could prompt the Fed to delay interest rate cuts.
But Fed officials, including Powell, have largely dismissed the Michigan reading, emphasizing that other indicators of inflation expectations remain steady. Williams added that policymakers must weigh how rapid shifts in trade, immigration, and fiscal policy will ripple through the economy.
“We have to assess what’s happening in terms of policies, what’s going on in the economy otherwise, and really think through where this balance of risk to achieving our goals is,” he said.
Even as tariffs begin to take hold, both Williams and Goolsbee said their inflationary effects could be “short lived.” Goolsbee used the term “transitory,” a word that once backfired on the Fed during the 2021 inflation spike, but which Chair Powell also used earlier this week.
Goolsbee noted that one-time tariffs without retaliation would be less concerning, but so far, that’s not how the trade conflict is playing out. Several US trading partners have already hit back with tariffs of their own.
The White House has announced it will unveil a new set of reciprocal tariffs on April 2, adding more uncertainty to the Fed’s outlook.
In the meantime, the Fed left interest rates unchanged for a second straight meeting, following a full percentage point in cuts last year. Policymakers still expect to deliver about 50 basis points of cuts by December, according to their latest projections, but eight Fed officials said they now anticipate one or no cuts at all.
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“The current modestly restrictive stance of monetary policy is entirely appropriate given the solid labor market and inflation still running somewhat above our 2% goal,” Williams said. “It also positions us well to adjust to changing circumstances that affect the achievement of our dual mandate goals.”
Shrinking balance sheet
The Fed announced it would slow the pace of its balance sheet runoff beginning in April. The cap on Treasury securities rolling off the balance sheet will drop to $5 billion per month, down from $25 billion.
However, the $35 billion cap on mortgage-backed securities (MBS) remains unchanged. That means no immediate relief for mortgage rates, which continue to feel the weight of higher bond yields and reduced Fed demand.
Williams said the Treasury runoff change is “a natural next step” and has “no implications” for monetary policy. But not all Fed officials agreed. Fed Governor Christopher Waller dissented, arguing the central bank still has enough reserves to maintain the current pace of reduction.
“Slowing further or stopping redemptions of securities holdings will be appropriate as we get closer to an ample level of reserves,” Waller said. “But in my view we are not there yet because reserve balances stand at over $3 trillion and this level is abundant.”
Investors shift to mortgage-backed debt
Meanwhile, mortgage-backed securities are drawing new attention from investors. As spreads between collateralized mortgage obligations (CMOs) and collateralized loan obligations (CLOs) tighten, money managers traditionally focused on corporate debt are increasingly pivoting toward agency-backed mortgage products.
According to Citigroup data, floating-rate CMOs backed by Fannie Mae and Ginnie Mae now offer spreads nearly equal to those of top-rated CLOs — a reversal of the usual spread advantage CLOs have enjoyed.
Firms like TCW Group and Columbia Threadneedle are expanding their CMO positions.
“Bond markets live and breathe, and if you remain in silos then you’ll miss out,” said Liza Crawford, co-head of global securitized credit at TCW.
TCW is focusing on Ginnie Mae-backed CMOs, while Columbia Threadneedle is using CMOs to reduce its CLO exposure. Jason Callan, co-head of structured assets at Columbia Threadneedle, said the shift is helping them manage credit risk as market conditions evolve.
If CMO spreads remain attractive, Citigroup’s Ankur Mehta said he expects more institutional investors to follow. That could reduce demand for CLOs, potentially raising borrowing costs for leveraged corporate borrowers.
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