Federal Reserve & Interest Rates

Despite the upbeat attitude surrounding credit markets over the past month, the fact is, bad loans are still a major problem that will likely severely impact the earnings of most bank for many quarters to come.  The mortgage securities market is still devoid of private investment and until it returns, the government, in the form of Fannie and Freddie will be the only ones buying up home loans.

Although there are some concerns, the commercial real estate market has yet to encounter the problems of it’s residential counterpart.  A lot will depend on how the economy fares for the rest of the year and what actions the government takes once it completes it’s stress tests for the nation’s largest banks.

Banks will continue to be tight with their money and many of them will hold back capital reserves to cope with expected future losses.  Despite the drop in mortgage rates recently, likely only those with good credit will be able to refinance, leaving a large segment still in danger of default.

The consumer credit situation will be bleak for some time and losses from bad credit card debt is a rising concern amongst most banks.  Rising unemployment is helping matters, as more and more people effectively lose their ability to repay credit.

Government loan modification programs will take some time to be effective and banks will obviously be reluctant to throw into question the value of mortgage securities once again, as it tries to re-attract private investment.  That’s the reason why mortgage markets are pretty much dead, no one knows what they are really worth.

In the short term we can expect the government to continue with it’s gradual nationalization of bank as it attempts to shore up their capital situations.

With the deadline for filing taxes coming up next week, not too long after that the first of the new stimulus checks will be going out to millions of Americans.  Consumer spending numbers will receive a much needed boost in the upcoming months.

However once that little jump is over like it was last year, economist will carefully watch those numbers in the fall up to the start of the next holiday shopping season.  Like last year the worsening  unemployment rate is also a major concern.

The unemployment situation plays a major part of consumer confidence and while financial markets may have improved by then the job market is expected to be weak for the rest of the year.  There is also the fact that while interest rates are low right now, there is less available consumer credit than there has been in years past.

There are also many conflicting views on how far off a recovery may be, there are some that feel that it’s just around the corner while some feel that it’s at least a year away minimum.  I’m of the feeling that we still have a ways to go, the housing market is still pretty much in shambles and while we have historically low mortgage rates at the moment, the credit situation hasn’t improved enough for the housing market to take full advantage, although it should hopefully put a brake somewhat on foreclosures as a record numbers of Americans refinance their existing mortgages.

The government’s plan to deal with the banking system’s toxic assets is still taking shape and it will be awhile before we can judge whether it will be successful or not.  Even so the most important thing the government can do right now is to keep any major systemic disruptions from affecting the economy for the near future.

Over the past few months we’ve seen the Federal Reserve increase it’s balance sheet activities once lowering interest rates no longer became an effective monetary policy tool, since they rates were already at zero.  Despite the trillions of dollars the Fed has poured into the money supply, they remain convinced inflation concerns remain negligible at this point in time and a big reason is because the Fed is basically acting as a substitute right now for institutional investors who are wary of even committing to short term money markets.

Most of that money has gone into seclusion in the form of the flight to quality into Treasury Securities.  Back in December, short term Treasury yields fell to zero, the first time that has ever happened.  Keep in mind that the government is also spending more money than ever and  is expected to run trillion dollar deficits for at least the next three years.

Despite what the Fed thinks, some investors are still wary of inflation with demand for 5 year Treasury Inflation Protected Securities(TIPS) causing yields to actually fall below 0% last month.  Some of this also has to do with the fact that non-TIPS securities of similar maturity are also trading at record highs, so even the most skeptical investor does not see long term inflation much higher than 2% over the next five years.

Now most people don’t think this situation will last too long, how can it?  What we are seeing is a lot of people hiding their money away waiting for the market to hit bottom but when it does many people think that money will come back to the market fast seeking higher returns.

Even after the institutional money starts flowing back, the Fed may not necessarily slow down the pace of their balance sheet activities.  There is a belief held by some that we may well see the Fed actually encourage a slightly higher rate of inflation than normal in a couple of years down the road.

Most predictions have the U.S. economy contracting between 4% and 5% this year and possibly more if the recession continues to drag on.  Therefore we may see the Fed continue to increase the money supply at it’s current levels in order to jump start the economy once the recession ends.