Federal Reserve & Interest Rates

The Commerce Department released it’s second quarter GDP data on Friday and it showed that the economy shrank by 1%, which was better than the 1.5% many economists were forecasting.  However while many analysts now feel that the economy may be on the brink of a recovery there are some caveats.

  The decrease in real GDP in the second quarter primarily reflected negative contributions from nonresidential fixed investment, personal consumption expenditures (PCE), residential fixed investment, private inventory investment, and exports that were partly offset by positive contributions from federal government spending and state and local government spending.  Imports, which are a subtraction in the calculation of GDP, decreased.

      The much smaller decrease in real GDP in the second quarter than in the first primarily reflected much smaller decreases in nonresidential fixed investment, in exports, and in private inventory investment, upturns in federal government spending and in state and local government spending, and a smaller decrease in residential fixed investment that were partly offset by a much smaller decrease in imports and a downturn in PCE.

Since the smaller than expected fall was primarily due to increased fiscal spending by the government don’t expect any big recovery anytime soon.  Consumer spending is expected to remain flat and with unemployment expected to grow through the end of the year, it’s probably not going to feel like a recovery for many Americans.

The housing market may or may not be finally hitting it’s bottom and the stock market remains down although it did stage a mini-rally this month.  However with many businesses still struggling and continuing to cut back on their workforce to control costs, it could be at least another year before jobs start growing again.

Until there is job recovery, consumer spending which makes up the bulk of the economy, will likely remain muted.  Many Americans are avoiding spending and as a result the overall savings rate has risen to around 5.2%.

Many Americans are still worried about the job situation, so there is no wonder that consumer confidence remains so low.  While this and last year’s stimulus payments provided a small boost to consumer spending levels, that only lasts for a period of a few months before falling back down once again.

Even if the economy does show some form of growth this year, the time frame for the recovery is expected to be long and slow process.  So much wealth was lost in such a short period of time and it could take years for it to grow back to their former levels.

There is a big debate going on right now on whether we should be concerned with inflation.  10 year Treasury securities have started to creep up recently, but it should come as no surprise as everyone knows that the government will need to sell substantial amounts of debt in the next few years.

There is no question that all the debt the government is piling up will increase inflationary pressures down the road.  However, the reason it’s not a problem for the moment because demand is so weak and the fact of the matter is, it could be quite some time before that demand recovers.

The Fed has in the past, shown it’s resolve in fighting inflation and there is no reason to believe that they won’t take the necessary steps to combat it once again if they feel it becomes a problem.  The main problem I see down the road is that the economy may be entering in a period of higher interest rates, which will be the likely outcome once all that government debt starts to flood the market.

The Fed will probably have to maintain it’s balance sheet operations and continue to be active participants in the Treasuries market if they don’t want those rates to get out of hand.  Even once the recession ends, it’s expected to take a long time for the economy to recover to it’s former level and that time frame may be lengthened if the Fed is forced to raise interest rates sooner than they wish.

A lot will depend on how quickly the financial system can recover and whether or not the government will have to spend anymore money to shore it up.  During the financial crisis the Fed has had to become the main driver of credit expansion in place of private investment once secondary markets for securitized loans started shutting down.  Since short term inflation expectations have been low, the Fed has had the leeway to act aggressively but that may not be the case a few years down the road if and when another recession occurs.

At the moment it’s too early to tell whether or not inflation will become a problem, as we’ve already glaringly seen with the price of oil for instance.  Everyone thought inflation was a big problem when oil hit $140 but not when it was under $40 a few months later.

The Federal Reserve announced on Wednesday that it would allocate an additional $1.05 trillion to purchase a combination of long term Treasuries and agency debt.  With interest rates pretty much at zero, much of the Fed’s focus has been on it’s balance sheet operations.

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. 

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

For the short term,  mortgage rates are expected to hit their lowest levels since World War II.  While this should help spur the housing market, it will still be up to the banking system to meet the higher demand for credit this move will create.

There are also concerns in some circles about the long term inflationary impact because in essence the Fed is pretty much printing money to purchase these  securities.  After the Fed’s announcement, commodities had their biggest one day rally in months.

Much of the concerns is over how quick the Fed will be able to reduce it’s balance sheet once economic activity returns to normal.  It is also likely that the Fed’s balance sheet will continue to grow since it seems apparent that the administration will face increasing difficulties in seeking additional funds from Congress to deal with problems in the financial system due to the recent public outrage over executive compensation.

For the most part, little has been done up until now to deal with the problems in the housing market when compared to the attention being paid to the banking system.  The problems with both areas are related and it would be foolish to think you could fix one without dealing with the other.

Hopefully the fall in mortgage rates, combined with the Treasury’s plan to purchase toxic assets will be enough to finally turn around a housing market that has been in the dumps since 2007.