federal reserve

Fed's game plan needs to take form

Wednesday, Aug. 12
Posted 8 a.m. EST

The Federal Open Market Committee meets today, with an announcement expected 2:15 p.m. EST. But an announcement of what? The Fed remains eons away from raising short-term interest rates, but the time has come for the Fed to be more specific about what it intends to do as the economic recovery continues.

Economic output, as measured by Gross Domestic Product, appears to have bottomed in the second quarter and a resumption of economic growth is now underway. After a long and deep recession, a great deal of economic growth must be seen in the next six to eight quarters in order to claw back what has disappeared since the fourth quarter of 2007. The unemployment rate will keep rising, notwithstanding the slight decrease in July, but it is definitely a marker of progress that employers are cutting jobs at a much slower pace than what was seen just a few months ago.

In the post-meeting FOMC statement, expect the usual cautionary statement that "conditions continue to warrant exceptionally low levels" in the federal funds rate to be maintained. After all, increasing joblessness, weak growth in household income and the reluctance of consumers to spend will, at the very least, cause some hiccups to the economic recovery if not an outright stumble at some point.

But Bernanke and company will need to place a greater emphasis on the need to preserve price stability now that the worst is behind us. In order to keep a lid on interest rates, particularly long-term rates, markets must be convinced that the Fed is willing to eventually put muscle behind that rhetoric and not cave to political interests. While under the purview of the Federal Reserve and not the rate-setting FOMC, the Fed will continue backing away from liquidity programs that have been used to prop up the economy and resuscitate credit markets.

A more immediate concern is whether the Fed will sunset or extend its purchases of Treasury securities set to expire in September. It is debatable as to whether these purchases have helped bring down long-term interest rates, but they have certainly kept them from rising. The Fed's decision to extend the program or not has implications for mortgage rates either way. If the Fed extends the Treasury purchase program beyond September, it will help keep a lid on mortgage and other long-term interest rates, or at least keep them from climbing as fast as they otherwise would as the economy reflates. But it will also fuel concerns that the Fed is either stoking inflation by continuing to pump money into the system or that its is monetizing the U.S. budget deficit.

Failure to extend the Treasury purchase program at a time when the economy is regaining its footing and the Treasury continues to issue boatloads of new supply means there is little to restrain an upward march in rates. History has shown that interest rates go through spurts, moving a lot in a very short period of time and very little over longer periods of time. After kissing 4 percent in early June, the 10-year Treasury note has spent much of the summer in the 3.5 percent to 3.75 percent range, despite steady economic progress. If the Fed suddenly exits the Treasury market, we could quickly find ourselves playing in the 4 percent to 4.25 percent sandbox, putting 30-year fixed mortgage rates over the 6 percent mark. Still low in a historical context, yes, but enough to throw cold water on refinancing activity and perhaps even quashing some prospective homebuyers' plans as well.

Let's also look out into 2010. This year, the Mortgage Bankers Association forecasts $2 trillion in mortgage originations, and the Fed is buying $1.25 trillion of that. Will the Fed continue to buy agency mortgage-backed securities in large quantities after the end of the year? And if not, is there enough demand to soak up whatever the Fed doesn't buy? The Fed will need to carefully calculate in order to keep mortgage rates below 6 percent.

While we're still some time away from an increase in short-term interest rates, the Fed's game plan must take form and be verbalized now in order to keep interest rates from climbing too fast and to quell concerns about eventual inflation.


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