Federal Reserve & Interest Rates

Vice Chairman of the Federal Reserve, Donald L. Kohn, spoke briefly about the Fed’s exit strategy during a speech before the Cato Institute’s Shadow Open Market Committee meeting on Wednesday.

In its most important aspects, the decision about when to begin exiting from the unusual policies is not materially different from any decision to start tightening monetary policy. We will need to begin to remove the extraordinary degree of accommodation in its various dimensions when we judge that exiting from the current stance of policy will be necessary to preserve price stability as the economy returns to higher levels of resource utilization.

The recovery is going to be a slow process, so it’s not like the Fed will have to shrink it’s balance sheet overnight.  Even so, Kohn remarked that interest rates are expected to remain low for an “extended period of time”, echoing the sentiments of last week’s FOMC meeting which kept rates at near zero.

A lot will depend on the employment picture, the Labor Department will be releasing is job’s report for September on Friday, and many economists are predicting that the unemployment rate could stay above the 9% range into 2011.  Job losses have slowed the last few months and that trend is expected to continue, but those jobs aren’t going to be replaced anytime soon.

The Fed will finish it’s purchases of Treasuries by next month and has slowed the pace of it’s purchases of agency mortgage securities and will finish that program by next spring.  They will slowly unwind their liquidity facilities, which are still needed at the moment since lending activity has yet to return to normal.

The Fed will have to balance increasing inflation pressures as the economy improves and try to avoid a possible “double dip” recession that could occur when rates start rising once again.

One of the biggest causalities of the financial crisis was the breakdown of Asset Backed Securities(ABS) market.  The loss of confidence by private investors in asset backed securities has lead to the Federal Reserve having to try to fill a void that is an integral part of the credit system.

The collapse of the ABS market has lead to larger spreads and higher borrowing costs to consumers and businesses.  Assets with high default rates have made these securities difficult to trade and many bank were forced to take write downs leading to a capital shortfall for many institutions.

The Fed has pretty much had to subsidize investors in order to get them back into the marketplace.  By creating the Term Asset Back Loan Facility(TALF), the Fed has committed to up $1 trillion to get this market back on it’s feet.

However, eventually the Fed will be starting it’s exit strategy with economic conditions improving and it will be vitally important for private investors to pick up the slack.  At the moment the TALF is set to expire on March 31, 2010 and while issuance of ABS has increased in recent months, it is still a far cry from where it was before the financial crisis began.

To no ones surprise the Federal Open Market Committee voted unanimously to leave interest rates unchanged today at their regularly scheduled meeting.  With economic activity starting to pick up, many investors believe the Fed may start their exit strategy fairly soon but at the same time keep rates low for some time to give a chance for the employment situation to improve somewhat.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt.  The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.  As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009. 

The purchases of agency mortgage securities was originally scheduled to finish up by the end of the year but slowing the pace of their purchases by another quarter makes sense as it gives more time for the financial situation to improve.  The Fed is hoping there will be investors who will be able to pick up the slack once they leave the market.

A jump in mortgage rates may be impossible to avoid once they finish up their purchase program and while the housing market has shown some signs of improving in the past few months, it still has a ways to go before it returns to normal.   The Fed has also announced that it will gradually shrink it’s credit facilities to financial institutions which they created in the aftermath of the Lehman collapse last year.

The Fed plans to wrap up their purchases of Treasury securities sometime next month and it will be interesting to see what effect it will have on yields once they leave the market.  Foreign demand remains strong for the time being so yields shouldn’t rise too much but even that is uncertain.

The Fed will likely keep a close watch on inflationary pressures and make an changes to their exit strategy as needed.