Fed President Puts Timeline on Rates Policy. Raises Doubts on Mortgage Purchase Program
Last night New York Federal Reserve Bank President Bill Dudley appeared on the PBS Nightly Business Report.
Before going into detail about what he discussed I think its important to point out that the New York Fed President hasrnmore influence than his counterparts. The New York Fed president servesrnas the FOMC'svice chairman and is arnpermanent voting member of the Federal Open Market Committee. It isrnalso interesting to note that the NY Fed President is usually expectedrnto keep a low profile, with that in mind, Dudley's willingness to sharerninsight and perspective should be taken as an “out of the ordinary”rnevent.
Dudley made several comments that need to be called to your attention. Here are a few:
ON THE ECONOMY...
- “We are in the middle of the beginnings of an economic recovery”
- “I think it's a recovery that isn't as strong as we would like”
Plain and Simple:we are experiencing a stabilization from record low levels of economicrnactivity. The historical trend of post-recession economic rebounds isrnnot likely in the case of the current GREAT RECESSION. The extent tornwhich jobs were lost is one problem, the bigger problem is jobrncreation. Many of the jobs that were lost over the past two years mayrnhave been lost forever thanks to increases in labor productivity and anrnexpected surge in technology investments. Basically, businesses willrnlook to invest in the most efficient means of production to keep costsrnlow in the future.
ON INTEREST RATE HIKES…
When asked what he would need to see before he would feel comfortable voting for an interest rate hike, Dudley said:
- “I certainly need to see an economy that's vigorous enough to bring the unemployment rate down, number one.
- “And two, I would care about what's going on in inflation… We'rerndoing very well on the inflation side. We're doing not well at all onrnthe employment side,”
- “What I'm really looking for is to watch job growth, thernunemployment rate coming down, and as long as inflation's well behavedrnthen I'm going to be pretty patient on the other side.”
- “What I want to stress is extended means at least six months. It couldrnbe a year from now.. two years from now. It's going to depend on howrnthe economy develops.”
Plain and Simple:In regards to monetary policy, the Fed has a dual mandate to promoternstable inflation and maximum employment. When forecasting interest raternhikes we can look towards these two metrics to provide a hint ofrninterest rate hikes to come. It's very clear that inflation is not arnmajor concern to the Fed. At most the Fed is worried about a spike inrncommodities prices (COST PUSH INFLATION).rnHowever, given weakness in the labor market, consumer demand will notrnsupport a rise in the cost of produced goods, therefore a rise inrncommodities prices should be viewed as counterproductive to economic rnrecovery efforts. (If the cost of inputs rises and firms are unable tornsell their product for a higher price, profit margins will bernsqueezed). Lastly, the highly watched FOMC statement phrase “EXTENDEDrnPERIOD” was given a timeline by Dudley. This is important becausernthe bond market will price in a Federal Reserve interest rate hike wellrnin advance of the actual rate hike. This means mortgage rates wouldrnrise well in advance of a Federal Reserve rate hike….as in 6rnmonths before the market thought the Fed would raise rates. The nextrnFOMC meeting is in late January, don't expect the FOMC statement tornshed the phrase “Extended Period”.
ON THE FED'S MORTGAGE BACKED SECURITIES PURCHASE PROGRAM…
- It would “seem prudent” to pull back on the Fed's mortgage-backedrnsecurities purchase program now that the economy is starting to improve.
- “If we were to wait and see what happens, that means we'd have tornkeep purchasing which would mean our balance sheet would get bigger,”
- “So that would create anxiety on the other side. Some people arernworried about the size of our balance sheet. I don't think we have anrnexit problem. I think that we're going to be able to manage our balancernsheet down very, very smoothly.”
- “Obviously, if mortgage rates were to back up a lot and if that hadrna big consequence for the economy then we could very well rethink thernissue about whether we wanted to buy more mortgages,”
Plain and Simple: Since Ben Bernanke first hinted at a possible extensiona few more Fed officials have suggested extending mortgage-backedrnsecurities purchases beyond the March deadline. Many market watchersrnbelieve this will prevent potentialrnsetbacks in housing markets. Dudley however says it would “seemrnprudent” to pull back on Fed MBS purchases. Basically, by callingrnattention to the size of the Fed's balance sheet Dudley is telling usrnthat if they Fed continues to hold the hand of the market, that it willrnbe harder and harder for the Fed to exit the mortgage market. He did not totally close the door to an extension though, if mortgage rates rise to the point where loan supply is much less than forecast (which is already expected to be very low relative to this year), the Fed would need to step in and buy more mortgages.
Given the already weak outlook for loan originations in 2010, it sounds like its going to take a major downturn in housing for the Fed to extend the MBS Purchase Program. One thing is for sure though, in order for the MBS market to continue providing funding for loan originators, the US government will have to EXPLICITLY guarantee agency MBS cash flow investments.
We get a look into President Obama's plan in February when he releases his 2011 Budget. More to come on why MBS market supply and demand dynamics make it very possible for the Fed to exit the MBS purchase program in March.
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