Fed Policy Considerations, Inflation & Mortgage Rates. Thinking Out Loud...
Fed Policy: CLEARLY ON EVERYONE'S MIND. Including mortgage rate watchers....
From MND Mortgage Rate Watch...
POTENTIAL ALERT: Mortgage rates are back at record lows because investors are anticipating the announcement of another Federal Reserve Quantitative Easing program sometime before January. Many believe this program will be concentrated on Fed purchases of Treasury debt or some other AAA asset. If this strategy were to be employed, it would be highly supportive of a low mortgage rate environment. However, one of the main motivations for another QE program is the notion that inflation is below the Fed's target. There is growing concern that the U.S. is already being sucked into a deflationary spiral, similar to Japan's economy which has floundered for the last 20 years for a few similar reasons (eg.loans to dummy corporations). If the Fed is really concerned about raising the market's inflation expectations, then perhaps we are not thinking outside of the box enough here in terms of the means they are willing to take to accomplish their goals. Perhaps we are missing the boat on what strategy they chose to employ. Perhaps the Fed doesn't purchase Treasuries? Maybe the Fed hikes rates??? Maybe there is some new asset swap window??? We're not sure yet, but in my opinion more Treasury purchases won't be as helpful in sparking growth as they were in stopping economic contraction. For example, record low mortgage rates haven't done much to spark a boom in housing but they've clearly helped housing work through the bottoming process. We know the Fed is strongly considering and probably already planning a program, but we cannot automatically assume this program is geared toward pushing benchmark yields and mortgage rates even lower. For this reason, I am very defensive about these record low mortgage rates. I am just not convinced the Fed isn't planning a "shock and awe" attack on disinflation AND employment. Something we wouldn't have expected....
Recent Fed rhetoric below. Some observations. This is me thinking aloud...
BEN BERNANKE: The Economic Outlook and Monetary Policy, JACKSON HOLE: 8_27_2010
"First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost trade-offs of some of our policy tools could become significantly more favorable."
PLAIN AND SIMPLE: That sounds like a threat! Ben had his hand the holster back in August. He even acknowledged "further disinflation"
Ben adds, "Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability."
PLAIN AND SIMPLE: Next Ben acknowledges the potential for a downward spiral, "weakening in the economic outlook would likely be associated with further disinflation". Ben faces the toughest of challenges, taming the FOMC's two headed mandate monster...promoting maximum employment and price stability...at the same time! Talk about walking a tightrope....
BILL DUDLEY: The Outlook, Policy Choices and Our Mandate: 10_1_2010
"Low and falling inflation is a problem for several reasons. First, low and declining inflation makes it harder to accomplish needed balance sheet adjustments. That is because, all other things being equal, lower inflation means slower nominal income growth. Slower nominal income growth, in turn, means that less of the needed adjustment in household debt-to-income ratios will come from rising incomes. This puts more of the adjustment burden on paying down debt."
PLAIN AND SIMPLE: We cannot start growing until were done shrinking. Americans have done a good job de-leveraging (delinquencies too), but if we enter a low inflation environment, a greater percentage of your new income will go toward servicing your old debt (or if commodity prices rise. more income spent on higher energy costs. REMINDER: the value of the dollar is really important!). This would make it difficult to build a recovery around wage growth. Americans would be stuck in the mud. Plus, you have to have a job to have wage growth. Businesses are increasing productivity via technological advances as well as getting more out of the people who are still on the payroll. This doesn't paint a pretty picture for folks who just can't seem to find a job, not to mention those who already gave up. We need job creation and wage growth. Obama's infrastructure plan needs some debt investors...BABs anyone??? BUILD AMERICA BONDS AND SCHOOL BONDS: INVESTING IN OUR STATES, INVESTING IN OUR WORKERS, INVESTING IN OUR KIDS
Bill goes on, "Second, and even more importantly, low and falling inflation can cause inflation expectations to decline. This is important because inflation expectations are an important factor that influences actual future inflation. Moreover, when inflation expectations decline, the expected real cost of credit increases—a subject I will return to in a moment."
PLAIN AND SIMPLE: This implies the Fed's communication strategy is CRUCIAL! And it is. If the Fed wants to spark some inflation, the Fed needs to make people believe inflation they mean business about avoiding deflation. Of course a huge budget deficit combined with poor growth prospects should be enough motivation for that, but fiscal concerns just don't outweigh flight to safety demand, not yet at least. Nonetheless, Ben felt the need to talk about fiscal policy last Friday ....he isn't supposed to be talking about the budget in regard to specific executive policies like HEALTH CARE. CONTROL + F and search "HEALTH CARE" in this speech. Weird. Not sure why he crossed that line. Maybe he is tired of getting poked and prodded by Congress and wanted to take his own shot? Doubtful. Not his style IMO. Anyway, in regard to the crucialness of the Fed's communication strategy, "Shock and Awe" seems like a necessary evil if the Fed is to successfully put the fear of inflation back in the minds of America (the World). Rate hike anyone????
One thing is obvious: the Fed is looking to spark a little inflation. Bond yields do not like inflation. How would the Fed manage to control inflation without pushing mortgage rates higher? Eh. Maybe not a big deal. Low rates are not the solution to the problems of the housing market so higher rates aren't necessarily a bad thing. As long as the average 30-year fixed is below 5.00%, housing will get by. I think the Fed could pull this off with targeted MBS purchases in the production side of the stack (Bernanke said more MBS purchases were possible at Jackson Hole). Plus, just because we're talking about inflation doesn't mean the US recovery is going to turn on a dime. The economic environment is expected to remain highly supportive of low mortgage rates, all on its own. The road ahead is LOOOOONG. We should all get used to it....
Still so much more to consider. Much more to come. Feedback appreciated.
Open discussion forum below....