Federal Reserve & Interest Rates

The Federal Reserve recently announced that it would extend it’s Term Asset-Backed Securities Loan Facility(TALF) until March of 2010 and chances are they could extended it again next spring.  The Fed created the program to promote borrowing and lending in the asset-backed securities(ABS) market which froze up during the financial crisis.

Bank lending is still down overall, as can be seen with the excess amount of bank reserves the Fed is currently holding on deposit.  The ABS market is essential in helping banks rollover existing loans in order to facilitate new lending.

New issuance of ABS has slowly started to return but investors still remain skeptical, especially for securities backed by real estate loans, which is still experiencing a high degree of defaults.  That being said, the TALF has still had a positive impact as investors are increasingly starting to use their own cash to re-enter the market.

The market still has a ways to go to return to it’s former level, which may be impossible as financial institutions aren’t likely to return to their former leverage levels anytime soon.  The whole market is just too risk adverse at the moment, the Fed needs both issuers and investors to increase their risk seeking in order for credit to flow more freely.

As economic conditions start to improve we will likely see lending activity increase but it will probably be slow going for some time.

The U.S. budget is expected to run a deficit of about $1.8 trillion for the fiscal year that ends in September.  Even before adding in the estimated costs of the proposed healthcare reform bill making it’s way through Congress, the next couple of years will also likely see trillion dollar deficits as well.

Although inflation isn’t a concern for the time being, a lot of people are watching out for it in the corner of their eye.  Noted investment guru Warren Buffet also raised concerns about the long term risks to the economy in a piece this week in the New York Times.

No one really likes to talk about it, but it’s a big problem that isn’t going away.  Can we really count on a future Congress to deal with this problem in an appropriate manner?  Not likely if you go by how past Congresses dodged the growing Medicare and healthcare problems to the point where the current Congress has to deal with the problem during the worst financial crisis since the Great Depression.

That being said no one really knows when or how much of the money the government lent out to financial institutions it will get back.  Some people are saying taxpayers will be on the hook for most of it, while others are saying the government may actually turn a profit by selling it’s equity stakes when markets recover.

It’s not a problem as long as there is enough demand for U.S. treasuries but once it passes that tipping point all bets are off.  This country hasn’t really had an inflation problem since the recession of the 1980’s but the one that’s coming could make that one look like a distant dream.

Now the Fed could fight it by raising interest rates but that would also send economic growth down at the same time.  Since no one knows who the next Chairman of the Federal Reserve will be next year, we don’t know if a future Fed will place a premium on fighting inflation or maximizing employment.

There are too many variables to the problem to accurately determine how this will all play out but it is a cause for concern.

The Open Market Committee once again agreed to keep interest rates unchanged at between 0% and .25% this week.  As long as inflation concerns remain muted they would prefer to keep rates as low as possible in order to stimulate a faster recovery.

Although last quarter’s GDP numbers were still negative, they were better than what many economist had forecast and there are increasing signs that economic growth will turn positive by year’s end.  While that may be the case, it should be pointed out that with consumers unable to do so, it has fallen to the federal government to try to spend it’s way out of the current recession.

It will still be some time before consumers will feel like there’s an actual recovery with unemployment expected to climb up to the end of the year.  Whether or not the Fed will be able to keep rates at their current level until there is actual job growth remains the big question.

Much of this will depend on how the price of oil reacts as economic conditions start to improve, if speculators start pushing the price up once again, like they did a year ago, it could quickly derail any chance of a timely recovery.   That would also likely lead to a rise in commodity prices in general but at this point the demand figures would seem to preclude that.

If rates can remain low for an extended period of time, it would also go a long way in helping out the housing markets, which has seen increased buying activity in recent months.  However, high foreclosure rates remains a problem for the banking system, clogging their balance sheets with toxic assets.

So even if GDP does start to rise once again in the next couple of quarters, it doesn’t mean by any stretch of the imagination that we are out of the woods yet.