How will the Fed’s exit influence mortgage rates?

3-Federal-ReserveThere’s no end in sight to the Fed’ ongoing efforts to keep mortgage rates low. At least not at the moment. However, the Federal Reserve faces a very real set of risks if they decide to kill their programs too soon or allow them to run too long.

A mistake either way will prove consequential for mortgage rates.

While these concerns remain in the future, sooner or later we will see a message concluding an FOMC meeting which says, “The committee has decided to reduce the Fed’s purchases…” and we’ll see how well prepared the stock, bond and housing markets are for the change.

If the Fed exits too early…

While a gradual exit is the most likely course–the Fed will slow purchases of Treasurys and/or MBS–removing even a portion of the demand for these items in the market will cause their prices to fall, and yields on interest rates to rise.

While the immediate impact of rising mortgage rates would probably spark a flurry of home buying initially, a slowdown of activity due to higher costs would eventually occur.

There are other considerations, as well.

To the extent that low rates are supporting economic activity, higher interest rates would tend to diminish it. An early exit by the Fed–or slowing purchases quickly–could cause the economic expansion to stumble, leaving us in a more stagnant pattern at best as the economy adapts to higher credit costs–if it can.

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Any measurable slowing would likely necessitate further support by the Fed–a restarting or re-expansion of the support programs–in order to give the economy another boost. While economic trouble can bring lower rates, monetary policy in fits and starts is not something the markets would likely welcome.

If the Fed programs run too long…

So there is an economic risk of exiting too early or too abruptly. There is also a risk of running these programs too long.

At some point, all the new dollars being pumped into the economy each month will begin to push their way back into the economy, and that might create an inflation spiral. While the Fed has been fighting deflation for the last couple of years, if the Fed continues to pour cash into the economy past the point where the economy needs the additional funds, a bout of inflation may result.

In general, the solution for a bout of inflation is higher interest rates, for a time; how high rates would need to rise to quell inflation is uncertain.

The Fed faces a host of questions

There are still a host of questions tied to the removal of these extraordinary monetary supports:

  • At what point should they be removed?
  • How will they know when it is time to do so?
  • How quickly should things be changed?
  • Should the market be prepared in advance for them?
  • Are the Fed’s stated milestones actually triggers, or will things be moving long, long before we hit them?

Perhaps the more important question is, “What is the reaction of an economy which has become dependent upon historically low interest rates to function when they are no longer available?”

At least that’s tomorrow’s problem, at least for now.

HSH Associates Financial News Blog

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