Why the Federal Reserve should buy national infrastructure bonds

December 28, 2012

The Federal Reserve is in the middle of a third round of bond buying that is commonly called quantitative easing (or QE3). The goal is to suppress interest rates, and it was the main monetary policy tool that the Fed began using in December 2008 to support the financial system during the credit crisis. The financial system has returned to racking up record-breaking profits, and the Fed has shifted the purpose of QE to propping up the housing system and the general economy.

By some measures though, the housing market may be showing bubble-like properties again from the broad efforts of the Fed. Rather than potentially fueling a new bubble, the Fed should turn to buying infrastructure bonds to rebuild America’s energy grid, bridges, roads, rail systems and ports. This would be a direct investment in the public sector of the nation, rather than the personal assets of households. If the Fed invested in America’s hard assets, it would create jobs and put in place the necessary framework to truly spur economic expansion.

The efforts of the Fed to prop up the housing market may be entering bubble territory in select markets (see Phoenix) as housing values rise more quickly than household incomes. From the blog Dr. Housing Bubble (emphasis mine):

The Case Shiller data is showing a steady increase in home prices across the United States. The headline figures are clear but rarely make the connection that much of this gain is coming on the back of unprecedented Federal Reserve intervention.  Data is clear that household income is not making any significant gains.  These gains are coming largely from added leverage produced by lower mortgage rates.

The Fed’s aggressive efforts to prop up the housing market through their purchases of mortgage-back securities (they own $933 billion) has lifted existing home sales back to their bubble-high of 2007 and helped lift housing prices. It has also given credit-worthy borrowers a chance to refinance their mortgages to lower rates and free up cash for other purchases. Although the Fed will only buy mortgage-back securities (MBS) that are guaranteed by agencies of the federal government (Fannie Mae and Freddie Mac) its intervention has trickled throughout the entire housing market.

However, the Fed’s MBS buying program has had limited success for new home sales. At the October 2012 level of 368,000, they are languishing at about half their 2007 high of 776,000 annual units, according to the National Association of Home Builders. New employment is usually generated by construction of new homes rather than the sales of existing homes. So this leg of the Fed QE program has had limited success in spurring employment. Without growth in household income or loosened lending standards, new home buying is unlikely to accelerate quickly.

The Fed recently upped its buying to a rate of $85 billion per month, which has lowered interest rates further. This puts its annual cumulative purchases at around $1.02 trillion of securities. The Fed executes QE through buying U.S. Treasuries and MBS.

The Fed’s QE strategy for the economy is two pronged: First, when the Fed buys MBS, it pushes down interest rates for mortgages and helps prop up housing values. Second, the Fed’s bond-buying program lowers yields on U.S. Treasuries and MBS and pushes investors into stocks and higher-yielding securities like corporate and municipal bonds. This causes those assets to rise in value and it generally creates a “wealth effect” for those who own financial assets.

The effort to raise asset values, like the Fed’s efforts to help homeowners refinance their mortgages to lower rates, is meant to free up household cash for spending. But, the recent holiday sales figures, which are currently showing a tiny year-over-year increase of 0.7 percent, suggest that households are not spending the surpluses they have gained from refinancing their mortgage interest rates or the additional wealth they have received through increased values of their stocks and bonds. The Fed has stretched the boundaries of its tools, and their effectiveness seem to be declining.

The Fed already has authority from Congress to buy the notes and bonds of state and local government. This authority is limited to buying municipal debt securities that mature in less than six months. A tiny change in the law by Congress could grant authority to the Fed to purchase bonds with maturities extending to 30 or 50 years, or the useful life of the asset being financed.

Getting this change through Congress would likely be easier than persuading the current chairman of the Fed, Ben Bernanke, that this course would more quickly revitalize the American economy. Almost two years ago, Chairman Bernanke said in a Senate testimony that he had no interest in any public financing, according to The Wall Street Journal:

Federal Reserve Chairman Ben Bernanke on Friday ruled out a central bank bailout of state and local governments strapped with big municipal debt burdens, saying the Fed had limited legal authority to help and little will to use that authority.

“We have no expectation or intention to get involved in state and local finance,” Mr. Bernanke said in testimony before the Senate Budget Committee. The states, he said later, “should not expect loans from the Fed.”

The Federal Reserve has bailed out or propped up the financial system, the housing market, equity, bond and MBS markets over the last five years. These efforts have succeeded in keeping the nation from a deflationary spiral, but they have done little to add productive assets to the economy. The Fed’s efforts have mainly been financial sleights of hand. Mr. Bernanke is unlikely to change course, but his term expires in January, 2014. Hopefully his successor will see the value of investing directly in America.

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