Federal Reserve & Interest Rates

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.

The Federal Reserve will have to walk a fine line in determining when to start it’s exit strategy as the economy starts to improve.  For the most part the recession is pretty much over but the recovery phase could be a long and arduous road.

Currently the Fed’s balance sheet is at over $2 trillion and as economic growth starts to return many investors are worried about the inflation implications, while at the same time concerned they might shutoff the tap to credit markets too soon.  The banking sector still has a ways to go before it can stand on it’s own and the housing market is slowly improving.

The Fed still plans to buy more mortgage backed securities(MBS) and their efforts to keep mortgage rates low has started to payoff with increased sales activity in the housing market in recent months.  Private investment has been slow to return in the MBS market and right now the Fed is the major buyer of these securities, which facilitate banks in turning over loans and extending more credit.

The announcement that Chairman Bernanke is up for another term of office, eases some investor’s minds as now they don’t have to worry about conflicting monetary policies if another person had been tabbed for the post.  The consensus is that the Fed already has an exit strategy in place but like everything it’s all about the timing.

The belief is that the Fed would like to keep rates at near zero through the end of the year as the labor situation is expected to worsen at least as long.  Consumer spending will be slow to return and it’s been the combination of both the government’s fiscal and monetary spending that has brought the economy out of the current recession.

Economic growth will likely be slow for an extended period of time so the Fed won’t have to act in a rush to shrink it’s balance sheet when the time comes.

A lot of uncertainty from investors were laid to rest with the announcement by the Obama administration that Ben Bernanke’s will be nominated for a second term as head of the Federal Reserve.  He may face some difficult questions during his confirmation hearings but most people feel his reappointment is a given.

It’s going to be a long road to recovery and the Fed will have a difficult task ahead as it tries to shrink it’s balance sheet as economic growth returns.  It will also have to balance it’s dual mandates of maximizing employment and price stabilization while coming to grips with the country’s mounting national debt.

The Fed has had to take a number extraordinary actions of the past year in order to avert a collapse of the financial system and being able to properly unwind those actions in a timely manner maybe just as important.  Both the economy and the banking system will be in a fragile state for years to come and avoiding a potential relapse will be the main focus.

Although the recession is expected to end soon, the Fed would like to keep rates low for an extended period of time if at all possible to stimulate growth.  There is still the employment situation to worry about and the housing market has yet to recover from it’s collapse from two years ago.

Consumer confidence is still low and until that demand returns, inflation expectations will likely remain muted for the time being.  It’s going to be a difficult juggling act once inflation rears it’s ugly head once again and it will with the national debt expected to double in the next decade.