The Fed needs to get its wallet out
The Federal Reserve is putting on a brave face about the rise in Treasury yields.
At the moment, the Fed can afford to put off bringing out the big cannons for a little while. If market optimism is overdone, a few weak economic releases would soon send interest rates plunging again. If the market is right, then higher rates are justified and the economy will cope.
But Fed policymakers, who next meet in two weeks, should be getting the artillery ready. They have already promised to buy as much as $300 billion of Treasuries before September.
Unless rates come down swiftly, this limit should be increased substantially.
So far, the Fed has managed to confound the skeptics of their unconventional monetary policy.
Fed intervention breathed life back into the commercial paper market and the program appears to be winding down. The purchase of mortgage securities has driven the spread between 30-year mortgages and Treasury yields down to pre-Lehman levels. The result was a spurt of mortgage refinancing.
Thursday’s rally in Treasuries notwithstanding, the recent run-up in yields is now threatening this great achievement.
Refinancing of home loans has already halved over the last two months and may grind to a halt. Around $3 trillion of Fannie and Freddie debt has a coupon of more than 5 percent.
With rates on a 30-year mortgage rising above 5.5 percent, it no longer makes sense to refinance. Mark Zandi of Moody’s Economy.com had expected Americans to save up to $30 billion in 2009 by locking in lower rates. This would require the fixed-rate mortgage to stay under 5 percent.
The rise in rates will also damage several federal programs aimed at kick-starting the housing market. The Homeowners Affordability and Stability Plan was created to allow those with very limited home equity to refinance. There will be few takers at current rates.
Similarly, the $8,000 tax credit for new homeowners expires on December 1 and will be largely wasted unless rates decline.
Against these possible outcomes, an additional round of Treasury purchases by the Fed poses relatively modest risks. The threat of an adverse market reaction — with nervous creditors dumping Treasuries and the dollar — is overdone as is the fear of inflation.
So far the Treasury Inflation Protected Securities suggest that investors have confidence in the Fed’s ability to keep inflation in check.
Even if the Fed buys its full quota of $300 billion in Treasuries it will still own less than 5 percent of the $6.6 trillion of outstanding market.
It can afford to buy much more before suggestions that it is monetizing the debt are to be taken seriously. After all the Fed is planning to buy $1.25 trillion in mortgage-backed securities by the end of the year — leaving it with up to a quarter of the total, according to Louis Crandall, chief economist at Wrightson.
The Fed still has great credibility, accumulated in the decades since it vanquished inflation under Paul Volcker. Now is the time to spend some of this credibility.