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After April 1, Fed May Stand Aside as Mortgages Wobble

Monday, 11 January 2010 09:46 AM

April Fools' Day will have a special meaning for the Federal Reserve this year: it will be the first day the central bank allows a ravaged U.S. mortgage market to stand on its own two feet.

Even if things are a bit wobbly at first, the Fed is unlikely to step in again after its debt purchase program — devised at the height of the financial meltdown — expires.

That would take a renewed crisis, like a sudden and destabilizing spike in mortgage rates.

Not that such a possibility is out of the question.

Some November data, such as housing starts and pending home sales — homes that are under contract to be sold — showed abrupt retrenchments after signs of improvement, suggesting government tax credits and the Fed's loan purchases were playing a big part in propping up the market.

Barring a double-dip in housing, however, Fed officials are unlikely to meddle.

Their reluctance to intervene anew has many roots.

For one thing, it would signal a policy about-face that could adversely affect markets as investors reassess what they believed was an improving economic outlook.

More importantly, it is unclear how much more impact the Fed could have on a market where it has already become by far the overwhelming source of demand.

Minutes of the Fed's December meeting showed a few members of the central bank's policy committee thought additional mortgage buying might be desirable under more adverse conditions.

Yet in the policy statement issued after the meeting, the central bank reiterated plans to shutter the program by the end of March and said it was proceeding to close down other emergency lending facilities on schedule.

"That was a fairly strong signal that they will not continue the purchases later on," said Torsten Slok, senior economist at Deutsche Bank.

Market analysts say a rapid spike in mortgage rates above 6 percent, up from current levels just above 5 percent, could get the Fed to rethink its stance, particularly if a spike is accompanied by a downturn in sales or prices.

Fed officials are hopeful, though, that their exit from the mortgage market will have much less impact.

Besides home loan rates, there are other impediments to a fresh round of mortgage-backed debt purchases, including the Fed's desire to keep inflation expectations under control.

One of the reasons the Fed capped its bond-buying program, which included more than $1.4 trillion in mortgage-related securities and $300 billion in Treasury debt, was the perception that the central bank was "monetizing" federal deficits — printing money to keep the government solvent.

This latent fear, prevalent in financial markets and reflected in the elevated price of gold, has the potential to turn more than $1 trillion in dormant excess bank reserves into a runaway rise in prices, analysts say.

Fed officials admit that such a prospect has given them a fresh perspective on the limits of monetary policy, leaving them little appetite for testing the market's boundaries.

If inflation expectations were to become unhinged, there could be a steep sell-off in the U.S. government bond market, pushing borrowing costs higher and potentially derailing what many still consider a fragile recovery.

Policy makers stress that, in a moment of extreme uncertainty, wiggle room is a huge asset, which helps explain why they want to keep all options on the table.

"We are still in uncharted waters," Fed Vice Chairman Donald Kohn said in a speech over the weekend. "We will need to be flexible and adjust as we gain experience."

But recent remarks from Fed officials indicate that they would like to move as quickly as possible toward a state of affairs where they can rely less heavily on unconventional policy measures.

Kansas City Federal Reserve Bank President Thomas Hoenig, one of the central bank's more hawkish members, stressed on Thursday that he would like to see policy tightened sooner rather than later.

"They're kind of in a no-man's land — never been here before, not sure what the street signs are, where the road bends," said Andrew Brenner, managing director at Guggenheim Partners. "But they're at the point where they would like to start reducing the balance sheet."

That's market parlance for the Fed's outstanding credit to the banking system, which has more than doubled to some $2.2 trillion.

As long as banks are reluctant to lend, this supply of funds has little bearing on inflation. But if the flood gates were to open too quickly, the consequences could be serious.

More mortgage buying would likely push the market closer in that direction, making the Fed's already difficult exit strategy all the more complicated.

© 2019 Thomson/Reuters. All rights reserved.

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April Fools' Day will have a special meaning for the Federal Reserve this year: it will be the first day the central bank allows a ravaged U.S. mortgage market to stand on its own two feet. Even if things are a bit wobbly at first, the Fed is unlikely to step in again...
Monday, 11 January 2010 09:46 AM
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