Mortgage Rate Threat: Fed Must Manage Rational Expectations and Maintain Credibility

By: • Fri, Nov 5 2010, 3:39 PM

Ok so we've spent the majority of our time recently discussing what the Fed was gonna to do, why they were gonna do it, and what happened after they did it.

QEII is here now. The Fed will spend somewhere in the neighborhood of $850-900 billion in the belly of the benchmark yield curve by the middle of 2011. For the most part QEII has been all fun and games for the mortgage industry. Rates are low and refinance demand is keeping the labor force afloat.

This leads me to pose the question...

WHAT ARE SOME POTENTIAL THREATS TO RECORD LOW MORTGAGE RATES?

First let me say, at this point in the recovery process I don't see another alternative to QEII. It was a necessary evil. I spent the entire month of October revisiting policy theories and reflation strategies in a high unemployment environment. QEII was a textbook response.

There is a major twist we all need to be aware of though. A twist that could throw a wrench in record low mortgage rates....

If QEII is to be effective, the Fed must expend much energy managing the market's rational expectations. This means the FOMC's communication strategy surrounding their inflationary targets is just as important as their asset purchases. Ben already set a new benchmark for Fed Chairman transparency when he published a Washington Post Op-Ed less than 24 hours after the FOMC announced QEII.

I quote Ben....

"Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation."

"Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills."

"This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

Plain and Simple: Ben intends reflate the monetary base (inflation) by boosting asset values and improving consumer confidence via job creation (from a weaker dollar) which he hopes will spark spending. Well, Ben better be careful because when he gets inflation, his ability to manage the market's rational expectations will ultimately determine if he is able to exit smoothly from his expansionary/accommodative policies. Rising commodity prices are already making folks nervous. If the cost of everyday necessities spikes without wage growth, disposable income and consumer spending will suffer. This would only serve to piss off American taxpayers even more, and we all know poo rolls down hill so you can bet your behind that politicians would be quick to put a finger in the eye of the FOMC. This is the last thing we can afford to have happen. We're walking a tightrope toward recovery. Turning America against the Fed would be like blind folding your bus driver on the highway in heavy traffic. We're stuck with QEII whether we like it or not. Unfortunately the plain truth is, even though Ben believes he is fully capable of walking us across this tightrope, there will always be skepticism, and the bond market is quick to reflect skepticism if there is enough of it.

THE FED MUST MAINTAIN CREDIBILITY IF MORTGAGE RATES ARE TO REMAIN THIS LOW

With that in mind, we should all get used to hearing Fed rhetoric. We should prepare for a healthy dose of jawboning and bully pulpitting. If Ben is smart, he will focus his efforts on convincing Main Street, John and Jane Public, that he has a plan, he is in control of his plan, and he knows how to wrap it up when the plan has run its course. Ben must convince taxpayers that it's time to move their money out of a mattress. Ben must convince Main Street to invest it in America's future.

Here is a damn good place to start...

Treasury Announces Build America Bonds issuances Surpass $150 Billion

Recovery Act Bonds Program Provides Infrastructure Financing to State and Local Governments, Saving Billions Compared to Tax Exempt Bonds

WASHINGTON – The U.S. Department of the Treasury today released its comprehensive monthly update on Build America Bonds issuances, including state-by-state data, showing that more than $150 billion have been issued through October 31, 2010. Build America Bond issuers benefit from substantial savings in borrowing costs when compared to issuing tax-exempt debt.

"In the beginning, Build America Bonds helped fill a critical hole in the municipal finance market left by the financial crisis. Now, Build America Bonds have now become an important source of financing to help state and local governments undertake much-needed infrastructure projects," said Alan B. Krueger, Assistant Secretary for Economic Policy and Chief Economist at the Treasury Department. "That state and local governments have now issued more than $150 billion of Build America Bonds and saved billions of dollars in financing costs in the process is a testament to their success and further evidence that the program should be extended."

Market reception for Build America Bonds has been very positive. Between the program launch on April 3, 2009 and October 31, 2010:

There have been more than $150 billion in Build America Bond issuances;
Build America Bonds now constitute about 21 percent of the municipal bonds market; and
There have been a total of 1,912 separate issues of Build America Bonds by local or state governments in all 50 states, the District of Columbia and two territories.

A complete list of issuances organized by state is available HERE.

The Build America Bonds program, created by the American Recovery and Reinvestment Act, allows state and local governments to obtain much-needed financing at lower borrowing costs for new capital projects such as construction of schools and hospitals, development of transportation infrastructure, and water and sewer upgrades. Under the Build America Bonds program, the Treasury Department makes a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the bonds.

The Obama Administration's FY 2011 Budget proposes to make Build America Bonds permanent with a 28 percent subsidy rate; this rate is estimated to be revenue neutral relative to the estimated future Federal tax expenditure for tax-exempt bonds. The budget also proposes expanding the eligible uses of Build America Bonds to cover a wider range of municipal borrowing, including original financings for public capital projects, current refundings for public capital projects, short-term working capital, and nonprofit 501(c)(3) organization financings.

BUILD AMERICA BONDS FACT SHEET

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Even if you're on the right track, you'll get run over if you just sit there.....