Fed President Puts Timeline on Rates Policy. Raises Doubts on Mortgage Purchase Program
Last night New York Federal Reserve Bank President Bill Dudley appeared on the PBS Nightly Business Report.
Before going into detail about what he discussed I think its important to point out that the New York Fed President has more influence than his counterparts. The New York Fed president serves as the FOMC's vice chairman and is a permanent voting member of the Federal Open Market Committee. It is also interesting to note that the NY Fed President is usually expected to keep a low profile, with that in mind, Dudley's willingness to share insight and perspective should be taken as an "out of the ordinary" event.
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Dudley made several comments that need to be called to your attention. Here are a few:
ON THE ECONOMY...
- "We are in the middle of the beginnings of an economic recovery"
- "I think it's a recovery that isn't as strong as we would like"
Plain and Simple: we are experiencing a stabilization from record low levels of economic activity. The historical trend of post-recession economic rebounds is not likely in the case of the current GREAT RECESSION. The extent to which jobs were lost is one problem, the bigger problem is job creation. Many of the jobs that were lost over the past two years may have been lost forever thanks to increases in labor productivity and an expected surge in technology investments. Basically, businesses will look to invest in the most efficient means of production to keep costs low in the future.
ON INTEREST RATE HIKES...
When asked what he would need to see before he would feel comfortable voting for an interest rate hike, Dudley said:
- "I certainly need to see an economy that's vigorous enough to bring the unemployment rate down, number one.
- "And two, I would care about what's going on in inflation... We're doing very well on the inflation side. We're doing not well at all on the employment side,"
- "What I'm really looking for is to watch job growth, the unemployment rate coming down, and as long as inflation's well behaved then I'm going to be pretty patient on the other side."
- "What I want to stress is extended means at least six months. It could be a year from now.. two years from now. It's going to depend on how the economy develops."
Plain and Simple: In regards to monetary policy, the Fed has a dual mandate to promote stable inflation and maximum employment. When forecasting interest rate hikes we can look towards these two metrics to provide a hint of interest rate hikes to come. It's very clear that inflation is not a major concern to the Fed. At most the Fed is worried about a spike in commodities prices (COST PUSH INFLATION). However, given weakness in the labor market, consumer demand will not support a rise in the cost of produced goods, therefore a rise in commodities prices should be viewed as counterproductive to economic recovery efforts. (If the cost of inputs rises and firms are unable to sell their product for a higher price, profit margins will be squeezed). Lastly, the highly watched FOMC statement phrase "EXTENDED PERIOD" was given a timeline by Dudley. This is important because the bond market will price in a Federal Reserve interest rate hike well in advance of the actual rate hike. This means mortgage rates would rise well in advance of a Federal Reserve rate hike. The next FOMC meeting is in late January, don't expect the FOMC statement to shed the phrase "Extended Period". I think its safe to say late 2010 is the earliest we might see adjustments to monetary policy.
ON THE FED'S MORTGAGE BACKED SECURITIES PURCHASE PROGRAM...
- It would "seem prudent" to pull back on the Fed's mortgage-backed securities purchase program now that the economy is starting to improve.
- "If we were to wait and see what happens, that means we'd have to keep purchasing which would mean our balance sheet would get bigger,"
- "So that would create anxiety on the other side. Some people are
worried about the size of our balance sheet. I don't think we have an
exit problem. I think that we're going to be able to manage our balance
sheet down very, very smoothly."
- "Obviously, if mortgage rates were to back up a lot and if that had a big consequence for the economy then we could very well rethink the issue about whether we wanted to buy more mortgages,"
Plain and Simple: Since Ben Bernanke first hinted at a possible extension a few more Fed officials have suggested extending mortgage-backed securities purchases beyond the March deadline. Many market watchers believe this will prevent potential setbacks in housing markets. Dudley however says it would "seem prudent" to pull back on Fed MBS purchases. Basically, by calling attention to the size of the Fed's balance sheet Dudley is telling us that if they Fed continues to hold the hand of the market, that it will be harder and harder for the Fed to exit the mortgage market. He did not totally close the door to an extension though, if mortgage rates rise to the point where loan supply is much less than forecast (which is already expected to be very low relative to this year), the Fed would need to step in and buy more mortgages.
Given the already weak outlook for loan originations in 2010, it sounds like its going to take a major downturn in housing for the Fed to extend the MBS Purchase Program. One thing is for sure though, in order for the MBS market to continue providing funding for loan originators, the US government will have to EXPLICITLY guarantee agency MBS cash flow investments.
We get a look into President Obama's plan in February when he releases his 2011 Budget. More to come on why MBS market supply and demand dynamics make it very possible for the Fed to exit the MBS purchase program in March.
By explicit guarantee I mean there is a line item on the Federal Budget that allocates funding for Agency MBS guarantees. At the moment, the current GSE prospectus does not have that...CHECK OUT THE FIRST PAGE