Federal Reserve & Interest Rates

The yield curve has started to flatten once again as renewed demand for Treasuries Securities has seen it’s price climb once again this month.  Despite optimism from some circles, investors remain skeptical that the economy will rebound any time soon.

The Federal Reserve reaffirmed it’s stance this month to keep interest rates at their current level at least through the end of the year, which will probably be necessary since the banking system is still in a weakened state. Also, with the housing market in it’s current state, there will be pressure to keep mortgage and other consumer interest rates low as well.

Even with the long term implications of the government’s massive debt, most experts expect short run inflation to be muted with the economy likely to show little growth for the next two years.  With confidence in price stability for the time being, the Fed can concentrate it’s efforts on fixing a bleak employment picture.

Much of the renewed interest in Treasuries has to do with a lack of confidence in the stock market.  There have been a few spurts here and there that have coincided with a rise in yields over the last six months but there have been no sustainable rallies.

Investors are jumping in and out of the stock market, taking profits and blunting rallies and quickly returning to Treasuries for shelter.  Many expect this scenario to continue for the foreseeable future as falling corporate earnings and weak consumer demand are expected in the upcoming quarter.

For now even though the supply of Treasury securities are going to climb in the near future, demand remains strong for the time being.

Although we’ve already seen the U.S. government pump trillions into the financial system to prevent it from collapsing, it is by no means out of danger.  Unfortunately, financial markets will most likely be in a precarious position for many years to come.

Investors have already shown some concern over the long term implications of the government’s massive debt load and in the past month yields on 10 year Treasury Securities have started to rise.  Despite the fact that global demand is weak and is expected to remain that way for some time, we have also seen commodities markets start to creep up as well.

Inflation concerns will likely hound the U.S. financial market for years to come.  It can’t hide from the fact that Treasury yields will most likely rise in order for the U.S. to fund it’s financial recovery plan.

This will have a spillover effect on consumer interest rates and will affect bond markets for years to come.  The primary weapon to fight inflation is to raise interest rates but while that may keep inflation in check, it also serves as a severe handicap to economic growth.

There are no free lunches, so while the government’s massive intervention may have kept it from collapse in the short term, that same intervention will most likely keep it in a weakened state for quite some time.  For now the dollar has kept it’s place as a reserve currency for the rest of the world but how long that will be the case remains to be seen.

The next few years will be very important, the severe debt load of the U.S. government was already a problem before the recent massive increase and will have to be dealt with sooner rather than later.  While technically the funds the government used to save the financial system were loans and are expected to be paid back, they face a significant risk of losses due to defaults.

A number of federal agencies with the Federal Reserve and the Treasury at the forefront, will face a difficult balancing act over the next few years in order to maintain the stability of inflation and interest rates and it’s overall effect on economic growth and the financial system.

Later this week, Treasury Secretary Timothy Geithner will unveil his regulatory reform plan before Congress.  How much it will resemble his predecessor, Henry Paulson’s so called “blueprint for regulatory reform” remains to be seen.

Regulatory reform of the financial services industry could take quite some time, with the current emphasis by the administration on healthcare reform.  However long it takes, the outcome will likely see the Federal Reserve exert a firmer control on the economy.

We may see some of the broad powers that the Fed has already used during the financial crisis become more institutionalized.  Also, some of the powers that are currently under the control of the Security and Exchange Commission(SEC) may also pass into their control.

The Fed is expected to gain regulatory power over institutions that are deemed systemic risks to the rest of the economy.  The SEC received a black eye when it failed to spot serious flaws in a number of financial institutions, most notably Bear Stearns and Lehman Brothers.

Other agencies likely to gain increased regulatory powers are the Federal Deposit Insurance Corporation and the Office of Thrift Supervision.  While much of the focus lately have been on the nation’s largest banks, hundreds of smaller regional banks face difficulties and a number of them are expected to fail in the next few years.

Ultimately we could see a considerable rollback of much of the deregulation that has occurred in the previous two decades and it will likely shape the financial landscape for years to come.