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Wednesday, August 12, 2009

Deconstructing the FOMC Minutes

Today's FOMC statement shows that while the politicians take blame and credit for the economy, the real economic puppet master of the economy is the Federal Reserve. Now, the Fed didn't change the Fed Funds Rate. It's still between 0-.25%. That's no surprise. The Fed essentially said that while things are still bad they are improving. In fact, the Fed referred to the economy as "leveling out". Here's their assessment of the economy.

Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

The Fed maintained that they will continue to support the economy, but the Fed stunned the financial world with this statement regarding their stance toward buying Treasury Bonds and Fannie/Freddie Mortgage bonds. Here's the pertinent statement.

To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October.

The Fed has said they would purchase up to $300 billion in Treasury bonds and a whopping $1.25 trillion in Fannie/Freddie bonds. They've been in the process of doing this for more than six months. Now, the Fed is essentially saying that the gravy train will end. Now, interestingly enough, only the 30 year Treasury bond showed a real effect to the news. That was up nearly 9 basis points on the day. The other treasury bonds had only marginal changes.

The Fed's aggressive purchase of these two debt securities is what I have referred to as "quantitative easing". This was the major stimulative activity over the last nine months plus. We will in the next few months going to see just how strong our economy really is. We'll also see just how artificially low interest rates are. Currently, the 30 year fixed mortgage is at about 5.5%. It's this aggressive quantitative easing that has 1)kept both Treasury bonds and mortgage rates at near record lows and 2)pumped trillions of dollars into the system. (that's because the Fed takes money from it's vault, or computer screen, which is out of the economy and buying bonds which puts that money into the economy)

The Fed clearly believes that our economy is strong enough to allow for interest rates to rise to their natural levels, whatever that maybe. They clearly believe that the economy is strong enough to withstand the rise in rates that will occur once they cut off the quantitative easing.

This move will be debated by academics and economists for years and decades. I have long asserted that the Fed's quantitative easing has masked the corrosive effects of the president's out of control spending. If I am right then sometime between today and the end of the year, interest rates on bonds will rise past 5% on the 10 year U.S. Treasury (it's currently at 3.7%) and the 30 year mortgage will shoot up to near 7%. More than that, the added borrowing costs will stunt growth so that we either don't get out of the recession or growth is miniscule.

Keep in mind that an extra 1% on your mortgage rate adds about $200 on a $200,000 mortgage. As such, if, and when, we see mortgage rates move up 1% or even more, that has the effect of forcing people to buy a property of about 10% less. So, such a move would put about 10% of downward pressure on real estate.

Now, it's important to understand that the Fed is merely setting in equilibrium what they had been artificially manipulating for months. The theory the Fed has is that they would artificially support the economy while it was weak. Now, it's stabilized enough on its own. So, from now forward, the economy will move forward on its own. It remains to be seen if the Fed is right.

1 comment:

Anonymous said...

Expect inflation to heat up once the economy recovers, it should have happened already but the Fed delayed this occurrence by paying banks interest on any excess they hold over reserve requirement. Once opportunity cost exceeds what the Fed can pay, the money supply will be increased effectively and inflation will soar.