Federal Reserve officials have been worried that their policy of ultra-low interest rates may be having less of an effect than usual because of a “broken transmission channel.” In plain English, this means the money hasn’t really been flowing smoothly from liquidity-flooded banks to would-be borrowers.
Economists at TD Securities argue banks have passed on less than half of their lower funding rates as reflected in yields on mortgage-backed securities onto consumers.
During the current iteration of monetary policy easing, pass-though peaked at 66% during the third week following the QE3 announcement, when MBS yields rebounded from their post-QE3 lows and 30-year mortgage rates fell to a record-low 3.36%. However, since the QE3 announcement, our calculations suggest that banks have passed through an average of just 40% of their lower funding rates (i.e. lower MBS yields) in the form of lower mortgage rates.
The concern was flagged in a speech by New York Fed President William Dudley this week:
Federal Reserve MBS purchases have succeeded in driving down mortgage rates to historically low levels. But these purchases would have had still more effect on the economy if pass-through rates from the secondary market to the primary market had been higher. As can be seen in Exhibit 3, the Federal Reserve’s purchases significantly narrowed the spread between agency MBS and Treasury yields, with the latest round of purchases significantly narrowed the spread between agency MBS and Treasury yields, with the latest round of purchases notably effective in this regard. But, as shown in Exhibit 4 the spread between primary mortgage rates and agency MBS yields3 has widened and this has limited the drop in primary mortgage rates.