Life after liftoff.

AuthorEngland, Robert Stowe
PositionMONETARY POLICY

When the Fed finally starts to normalize short-term interest rates, mortgage rates will start to move higher. Housing economists say the yield on 30-year mortgages could rise to 5 percent by the end of 2016.

In Samuel Beckett's play Waiting for Godot, the despairing duo Vladimir and Estragon reach wit's end waiting day after day for the mysterious Godot. At the end of the play, when Godot does not appear for yet another day, they agree to hang themselves on the morrow--unless Godot returns. [paragraph] One might have thought the financial markets were channeling Godot after the Federal Reserve's Federal Open Market Committee [FOMC] once again on Sept. 17 failed to raise the Federal Funds Rate, which has been stuck in a range between zero and 0.25 percent since December 2008. [paragraph] The day after the Fed held off raising rates, the Standard & Poor's (S&P) 500 Index plunged 32.17 points on heavy trading volume from 1,990.20 to 1,958.03. [paragraph] Over the next week, the market indicator bounced downward another 76.26 points to land at 1,881.77 on Sept. 28. Over a seven-day stretch, the S&P 500 lost 5.4 percent of its value or 108.43 points. [paragraph] Market observers tied the market's volatility in part to the Fed's failure to act after repeatedly indicating it planned to raise rates. [paragraph] "The Fed chose not to move and, frankly, it's not helpful for the economy, much less for housing," says Doug Duncan, Fannie Mae's chief economist. "Now what they've done is increase the uncertainty around the timing and nature of their next action. And the markets have shown that--some of the volatility is clearly related to that decision."

Market expectations for a September rate hike were raised by remarks made on Aug. 29 by Stanley Fischer, vice chairman of the Federal Reserve, at an annual economic symposium in Jackson Hole, Wyoming, sponsored by the Federal Reserve Bank of Kansas City.

There is "good reason to believe that inflation will move higher as the forces holding down inflation dissipate further," said Fischer. He was referring to the diminishing downward pressure on prices from a rising dollar and falling oil prices. In anticipation that inflation will move toward the Fed's 2 percent target inflation rate over the next few years, Fischer explained, the Fed could soon start the process of raising rates.

Persistent inaction by the Fed after such comments as those made by Fischer and other Fed officials is creating uncertainty, according to Duncan.

"There's now no way to know exactly what they mean when they make statements like Janet Yellen [chair of the Federal Reserve] made at her press conference [on Sept. 17] that she still expects rates to be raised by the end of the year," he says. "They've said that before, but they've not done it. There's no way at this point to know what or when they will do things," Duncan says.

The focus by markets on the timing of the first rate increase, while important, may miss the larger story of how high rates are likely to rise, according to Mike Fratantoni, chief economist at the Mortgage Bankers Association (MBA).

He says the market should also pay heed to the fact the Fed is going to move the rate eventually from zero to 3.5 percent and that the Fed considers 3.5 percent to be the right longer-term rate for Fed policy.

"In the Fed's view, they are trying to communicate to the markets that the fact they may move in December rather than September is not terribly important," says Fratantoni.

Fratantoni, however, sees the timing of liftoff to be more important than the Fed acknowledges. "The longer they wait, the faster they are going to have to raise rates. With faster rate hikes, that increases the risk they will unintentionally push the economy into a recession in the 2017 and 2018 time frame," he says.

Because inflation has remained low and has even fallen in the last year or so, it may have led the central bank to wait too long to raise rates, according to Mark Calabria, director of financial regulation studies at the Cato Institute, Washington, D.C. "The Fed is already far behind the curve. They should have moved a year ago. The Fed is in a box," Calabria says.

Expectations about future inflation--not just today's price increases--have also remained stable, giving the Fed considerable leeway to delay liftoff. The market, however, may eventually lose patience with inaction.

"If market participants start to believe the Fed is behind the curve, we can start to see that bleed into 30-year fixed-rate mortgage rates. So far, we haven't yet. And I don't think we will over the next year. But we might. Keeping an eye on inflation expectations is certainly important," Calabria adds.

The global economy

The Federal Open Market Committee, in a prepared statement on Sept. 17, explained that the group had decided against an immediate rate increase in part because "recent global economic and financial developments may constrain economic activity somewhat." The policy committee's fear was that a higher interest rate, no matter how small, might aggravate any slowing trend in the global economy already underway.

The Fed's decision on rates was made against a backdrop of slowing growth in China and an accompanying decline in commodity prices that has hit some emerging markets, like Brazil and South Africa, especially hard. There are also continuing worries about economic growth in the Eurozone, which over the summer endured yet another round of the Greek debt-default saga, as well as turmoil in the Middle East where ongoing conflicts could potentially interrupt oil supply and lead to a spike in oil prices.

Concern about the vigor and vulnerabilities of the global economy add a new wrinkle to the Fed's traditional focus on its dual mandate of stable prices and maximum employment that was enacted into law in 1977 in amendments to the Federal Reserve Act.

Inflation target

As for the Fed's mandate for stable prices, since January 2012 it has set an explicit inflation target of 2 percent. However, the inflation rate, as measured by the Consumer Price Index, has skidded along near zero in 2015 and was only 0.2 percent for the 12 months ending August 2015, according to the Bureau of Labor Statistics.

Clearly the recent pace of price increases is a long way from the Fed's 2 percent target. However, the Fed looks at the likelihood that prices will rise higher and, if the prospect is likely that prices will move above the target, as Yellen and Fischer have explained, it can lead the Fed to start raising rates to keep price increases in check down the road.

In an address at the University of Massachusetts on Sept. 24, Fed Chair Yellen again reassured the markets that the Fed would likely raise its target range for the Federal Funds Rate before the end of 2015.

In its September 2015 outlook report, the Fed projects inflation will rise from 0.4 percent this year to 1.7...

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