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Fed divide puts rates in question

By Holden Lewis · Bankrate.com
Tuesday, October 12, 2010
Posted: 5 pm ET

More than a year into our supposed economic recovery, members of the Fed's rate-setting committee can't agree on an explanation for the sluggish state of job growth.

As a result, it's not a sure thing that the Fed will try to depress long-term interest rates, including mortgage rates. They probably will, but would you bet the house on it?

The Fed's rate-setting Open Market Committee released the minutes of its Sept. 21 meeting today, and the minutes seem to indicate two notable disagreements. The first has to do with the stubbornly high level of joblessness.

Conservatives outside of the Fed have been arguing lately that much of today's unemployment is structural -- that some jobs have disappeared or have been moved overseas, and are not coming back, even after a full economic recovery. With this type of unemployment, you end up with a bunch of people who have skills that aren't in demand anymore. Yet at the same time, employers in other sectors of the economy can go begging for employees, but there aren't enough people equipped with the necessary skills.

Then there's the demand-side argument, which says unemployment and fear of unemployment lead to higher unemployment. For example, lots of teachers are being laid off. They dine out less, so waiters and waitresses get fewer tips, and spend less. The teachers who survived the layoffs keep their cars for another year instead of buying new ones, and workers in car assembly plants lose their jobs.

The high unemployment rate is caused by a mix of structural and demand-side joblessness. The disagreement, inside and outside of the Fed, concerns the proportions:

  • If low demand is mostly responsible for unemployment, then the Fed can pump more cash into the economy to stimulate demand.
  • If structural issues are mostly responsible for unemployment, then there's not much that the Fed can do to help -- and flooding the system with cash would harm the economy in the long run.

The second notable disagreement concerns inflation targeting. I'll explain that tomorrow. That way I can keep this blog post under 500 words.

The argument over the source of joblessness sounds abstract, but the way the Fed solves this disagreement will affect mortgage rates. If the demand-side Fedsters prevail, the central bank will buy Treasuries, and mortgage rates might fall some more. But there's a danger that rates would rebound sharply and rise too high in the future.

If the structuralists prevail, the overall economy would have to recover on its own. That path, too, might result in low mortgage rates for a long time.

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