Borrowing costs are probably due to rise even if the Federal Reserve has said it will keep short-term interest rates low, some experts say.
Any Federal Reserve plans to sell $1.1 trillion in mortgage-backed securities it holds will raise bond yields and ultimately, broader borrowing costs, says Mitch Stapley, chief fixed-income officer at Fifth Third Asset Management in Grand Rapids, Mich.
Any changes in Fed policy to keep interest rates low will also lead to higher borrowing costs.
Markets will be prioritizing every word that comes from Fed officials’ mouths over their actions.
“This market is going to discount anything they do from the immediate moment that the words pass their lips,” Stapley, who manages $13 billion in fixed-income assets, tells Bloomberg.
“The problem is the Fed needs the ability to work within shades of gray, and the market sees things in black and white.”
In other words, Federal Reserve Chairman Ben Bernanke needs to deal with a recovering economy.
It has kept rates very low for quite some time but it can’t keep them low once economic activity picks up if it wants to contain inflation.
Furthermore, it needs to trim its bloated balance sheet, which swelled to a record $2.34 trillion after the purchase of $1.25 trillion of mortgage-backed securities.
Any Fed announcement of shedding those securities would be the equivalent of adding 50 basis points to the yields on agency mortgage bonds relative to the benchmark rate, while even merely hinting that the “extended period” of low interest rates may end would send yields on two-year Treasuries to rise by as much as 50 basis points, Bloomberg reports. (One basis point is equivalent to 0.01%, or one-hundredth of a percentage point.)
“You’re obviously going to see rates back up,” says Paul Gifford, chief investment officer at 1st Source Investment Advisors in South Bend, Indiana.
In late April, the Fed left its target interest rate near zero and reiterated its plans keep them that way even though the economy continues to improve.
The Fed has said it will keep rates “exceptionally low” for an “extended period” of time for over year.
“They don't want to do anything that might short-circuit the recovery,” says Anthony Chan, chief economist of J.P. Morgan Private Wealth Management, according to The Washington Post.
Last week, Boston Federal Reserve Bank President Eric Rosengren said the U.S. economy is showing signs of improvement but the recovery still has a long way to go and ultra-low interest rates are still needed.
Rosengren said in a speech to the Money Marketers of New York University that even with more positive recent economic data, the U.S. economy remains vulnerable to negative shocks, Reuters reported.
He said he agrees with forecasters who expect disinflation — a reduction in the rate of inflation — in the near term.
"With inflation expectations stable, core PCE inflation rates declining and significant excess capacity in the economy, accommodative monetary policy remains appropriate," he said.
Rosengren, seen as one of the more "dovish" Fed officials, more focused on economic growth than the risks of inflation, is a voter on the Fed's policy-setting Federal Open Market Committee this year.
The Fed cut interest rates to near zero in December 2008 and has kept them there since to aid economic recovery. It also pumped billions of dollars into the financial system by buying longer-term assets, more than doubling its balance sheet to over $2 trillion.
Rosengren spent much of his speech countering concerns that the Fed's extraordinary policies could fuel inflation once the economic recovery gathers steam. He said it would be "unusual" to see the inflation rate increasing in the early stages of the recovery.
"Even with rapid growth in the economy, spurred by accommodative monetary policy and stimulative fiscal policy, it is likely to take years before we approach the growth and inflation rates that would really reflect achievement of the two elements of the Federal Reserve's dual mandate," Rosengren said.
The Fed's dual mandate is price stability and full employment.
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