Federal Reserve & Interest Rates

The Federal Reserve announced that it was leaving interest rates unchanged in an FOMC statement released today.  It is likely that the Fed will keep rates at their current level as long as inflation expectations remain muted and the economy continues to contract.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

It will be interesting to see if the Fed will have to ramp up it’s balance sheet operation to keep mortgage and other consumer lending rates at their current low levels, once the government starts selling more and more of it’s massive debt that it has accumulated in order to fix the financial system.  There are concerns from some circles that yields could rise significantly once more and more Treasuries start flooding the market.

As for the banking system, initial signs show that it has enough capital to weather the storm, when the Fed released the criteria for the stress test being conducted on the nation’s 19 largest banks.  But with more losses expected down the pipe, is mere survival enough to turn around a credit system that has been floundering since the Lehman collapse.

In a perfect world the government would love to see the banking sector fully recover and use it’s credit resources to fuel a recovery but as long as capital is being held back to cover future losses, that’s just more money that isn’t being lent to the consumer.  It has also become apparent that the government is in favor of the current strategy of converting capital into equity in order to make what’s left in TARP go farther.

It would come as no surprise to me, if the Fed starts to release more money into the system later in the year if inflation remains muted, in an effort to spur growth, although a lot will depend on how markets react to the increased supply of Treasuries.  Until the current economic outlook changes however, you can expect a fairly high demand for Treasuries for some time.

As if things weren’t bad enough already for the global economy which has been gripped in the worst recession in decades, a new health scare has health organizations around the world deeply concerned.  The new swine flu which seems to have originated in Mexico has already claimed over a hundred lives in the country and new cases have already appeared in the U.S., Canada, Europe and Asia.

A number of countries have already issued travel advisories, which sent airline stocks tumbling in early trading on Monday.  The price of oil also saw a dip on concerns that global trade could be impacted.

Some countries have already issued an import ban on U.S. pork products.  Not surprisingly pork futures took a big fall on concerns that demand will fall sharply.

The World Health Organization is considering raising it’s alert level as fears of a large outbreak are a major concern.  Mexico has already closed all of it’s schools and other large public gatherings.

As was the case when the SARS scare occurred a few years ago, global tourism is also likely to see a decline. Over the past month it was thought the economy may be finally turning the corner, however this new health scare has served to dampen those prospects somewhat.

It remains to be seen how severe this scare will be and how much it will affect global demand.

Data from the last few months shows signs that the housing prices may finally have stopped falling, at least in most parts of the country.  While the housing market appears to have reached some sort of equilibrium between supply and demand for the time being, it may take quite some time for prices to rise once again.

What has many economists concerned is how unemployment, which is expected to rise to the end of the year, will affect the current dynamic.  The length of the recession will also play a large part and many parties are holding out hope that the worst is over.

There are several factors that will determine how the housing market plays out, most importantly interest rates.  How long can the Fed keep mortgage rates below 5% or near that level will be a major factor in how quickly demand returns.

Another factor is the status of the banking system and whether it will be able to fuel this demand, if and when it starts to pick back up again.  The Treasury is still finishing up it’s stress test for the banking system so it will be a little time before we know more fully the capital situation of the nation’s largest banks.

How inflation plays out will also determine how long the Fed can keep rates this low.  Also, once the government starts flooding the market with it’s new massive debt load, we will likely see yields rise.

Treasury yields and the spreads between it and other rates are really what matters most.  If Treasuries start to fall and yields go up, other rates are likely to rise in concert.

Unless the Fed is willing to commit to buy more Treasuries once again, rates can’t help but rise since yields right now are pretty much nonexistent.  But when the Fed buys Treasuries, that releases more money into the system and will fuel inflation concerns once again.

It is a delicate balancing act the Fed will have to play in order to navigate the housing market to recovery and it could take quite some time.