A revival of the housing sector and stability in prices is critical to a strong economic recovery. Central to Fed Chief Ben Bernanke’s plan to awaken the slumbering housing market has been to commit $300 billion to buy US Treasury bonds and over $1 trillion to purchase mortgage-backed securities.
By calming credit markets that had been spooked by the collapse of Lehman Brothers, the Fed’s goal has been to drive longer-term yields lower, encourage lending among banks, and inspire skittish consumers to re-engage.
Credit markets are functioning far more smoothly compared to late last year (see Credit Markets are Finally Melting), and the Fed does have the right to boast that its numerous actions have restored much of the confidence lost in the wake of Lehman’s demise. And for a while, the rate on a 30-year fixed mortgage fell comfortably below 5% because rates tend to mimic changes in the 10-year Treasury yield.
But in recent weeks, longer-term bond prices have tumbled and yields have jumped to their highest level in six months, threatening the Fed’s plan to jumpstart housing (see Bailing out of Bonds).
What gives?
For years, the Fed has focused on short-term rates, injecting and removing liquidity from the banking system in order to target the fed funds rate – the overnight rate banks lend to one another.
As the fed funds rate fluctuates, rates on a number of loans, including home equity and credit cards, adjust. Policymakers have only limited influence on longer-term bonds, leaving market forces to determine prices.
But the extraordinary events that rocked markets last year forced the Fed’s hand; hence, the decision to commit over one trillion dollars to government bonds.
Monetary officials are quickly learning, however, that manipulating the ten-year Treasury is a formidable task. The huge federal deficit brings with it an enormous supply of Treasury bonds while investors are waking up to the small but growing possibility that the US may lose its coveted triple-A rating.
The odds the US will ever default on T-bills or its bonds is incredibly remote, but a downgrade in the rating would slightly increase credit risks and therefore raise credit costs.
All the liquidity sloshing around the system and expectations of an eventual economy recovery later are also boosting fears about inflation, the mortal enemy of bondholders. And when the economy finally begins to expand, the Fed will be faced with the delicate task of withdrawing excess liquidity without sending rates sharply higher.
Given all of these forces conspiring against the Fed, the results were predictable and yields have surged. Going forward, there are no easy choices, only new challenges that Bernanke must deal with.
Charles Sherry
Tomorrow's Economy Today
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