Federal Reserve & Interest Rates

The Federal Open Market Committee met this week and to no ones surprise left interest unchanged once again and issued a press release following their meeting.

In these circumstances, the Federal Reserve will continue to employ a wide range of 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 continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

There have been call from some circles to raise interest rates recently, most notably from former Fed Chairman Alan Greenspan.  While GDP grew once again in the last quarter, signaling the end of the recession, numerous problems still lie ahead for the economy.

The banking system is still in a fragile state, with many financial institutions hoarding cash, still reluctant to lend to consumers whose demand for credit is also well below normal levels.  The housing market, while it has had increased activity as of late, has yet to recover and that could still be years away.

Consumer spending is also way down and many household have increased their savings rate, with an uncertain labor market for the foreseeable future.  The economy is just at the start of the recovery phase but much of the positive GDP growth from last quarter was mostly due to the fact of the increased fiscal spending the government has undertaken over the past year.

It may be as much a year, if not longer before the Fed raises interest rates once again or begins shrinking it’s balance sheet for that matter.  While the Fed has to be careful about timing it’s exist strategy, with the current state of the economy, monetary easing doesn’t appear warranted just yet.

The Federal Reserve has kept interest rates at nearly 0% for some time now and by all accounts it will remain at that level through next year.  Now over a year removed from the beginning of the financial panic, credit markets have yet to recover.

Consumers and businesses are reluctant to borrow and financial institutions are reluctant to lend, even with interest rate at historical lows.  Consumer spending has been stagnant and with demand still low, businesses are loathe to make capital investments.

Throughout the recession, the savings rate of American households continues to climb despite repeated efforts by the government to stimulate consumer spending through stimulus payments and incentive programs.  Although the economy is expected to return to positive growth this quarter, it’s been mainly driven though the government’s fiscal and monetary policy initiatives.

With it’s normal monetary policy tool exhausted, the Federal Reserve has had to use balance sheet growth to expand the money supply.  The federal government has also had to undertake massive budget deficits in order to rescue the financial system.

With the current state of the credit system, talks of exit strategies might be premature at this juncture.  Short term inflation expectations remains low but it is something the government will have to worry about in the long run.

Financial institutions are still trying to de-leverage themselves and hundreds of banks are likely to fail in the next three to four years.  Consumer confidence will also likely remain muted for some time with the labor market expected to take years to recover.

Despite the record growth of the national debt, a number of individuals have cautioned against the government reducing it’s fiscal spending anytime soon or the economy could see a series of fits and starts as it tries to recover.

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.