federal reserve

Low interest rates key to Fed's game plan

Friday Dec. 11, 2009
Posted 2 p.m. Eastern

"Another important factor has been the very low level of policy interest rates in the United States and in most other industrialized economies. Indeed, one of the purposes of these policies is to induce investors to shift into riskier and longer-term assets in order to lower the cost and increase the availability of capital to households and businesses. The more accommodative financial conditions, in turn, are intended to induce an increase in spending at a time when the level of output is expected to remain depressed for some time relative to the capacity of the economy to produce."
-- Federal Reserve Board of Governors Vice Chairman Don Kohn in speech Nov. 16, 2009

The Federal Open Market Committee meets Dec. 15 and 16 and maintaining interest rates at record lows "for an extended period" is still central to the Fed's economic game plan. Even a better-than-expected November employment report may prove to be a one-hit wonder and won't be enough to shift the Federal Reserve away from a cautious economic tone.

Keeping interest rates low, as the preceding quote states, incents investors to move into riskier assets. With the strong rebound in the values of risky assets since the depths of March -- not just equities, but junk bonds and commodities as well -- household balance sheets are nearly $5 trillion healthier now than at the end of the first quarter. This resulting boost in confidence helps spur spending. The Fed -- whether willing to admit it or not -- doesn't want to throw cold water on financial markets by raising interest rates until truly compelled to do so.

The question is, will they have the backbone to do it even then? The time will come for the Federal Reserve to bolster bond investors' confidence and head off a potential surge in bond yields but that remains an issue for another day. In the meantime, investors have flocked to the safety of government debt as a safe haven from financial turmoil in places such as Dubai and Greece, and as traders protect some of those year-to-date profits earned in riskier investments.

Bond prices and mortgage rates could come under pressure in 2010 as the Federal Reserve's mortgage repurchase program expires at the end of first quarter, but also if investors unwind their safe haven purchases or cool to the Treasury's ongoing debt issuance. The wrap up of the Fed's mortgage purchase program alone could see a spike of as much as a full percentage point in mortgage rates, should the Fed quit cold turkey. Knowing this, the Fed is all the more unlikely to end their purchases suddenly.

Will the Federal Reserve further extend the program in an effort to slowly wean the mortgage markets off its dependency? Or will it be compelled to re-up the program with a new round of purchases in an effort to keep mortgage rates at desirable levels? Ultimately, I believe we'll see one of the two come to fruition. But this isn't something that will be settled until the new year, and with the Fed wanting to retain maximum flexibility for whatever happens in early 2010, don't expect anything committal at this point that might only paint them into a corner later.

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