We will almost surely see today the Fed mark the beginning of the final chapter of the Great Recession. Pulling back out of the bond market interventions that has been a core part of the Fed’s strategy is going to be tricky, in part because shifts in interest rates have a direct impact on a still-fragile U.S. economy.
In the past, the markets have panicked at the mere mention of a cutback in Fed involvement, and (more recently) have also risen on the same news, presumably because people drew encouragement from the confidence the Fed was showing in the strength and resilience of the U.S. economy.
As the markets react, either upward or downward, there are a few issues to keep in mind. Despite the headlines soon to be blaring, the rate is expected to move very modestly from 0.125% to 0.375% — clearly a small first step in a long journey toward the long-term average. After each step, the Fed will evaluate the consequences before deciding to make future changes. If the economy slows, if there are signs that inflation is falling below the Fed’s 2% annual target, it could delay the next move by months or even years. That caution greatly reduces the danger of any kind of serious economic pullback.
FED’S EMPHASIS ON CAUTION
It’s also worth noting that the Fed has announced no plans to sell the nearly $4.2 trillion worth of various Treasury bonds and mortgages that it owns. At the moment, the bank is simply rolling over the portfolio, meaning it reinvests $21 billion a month as bonds mature. Eventually, most observers expect the reinvestment to stop and the Fed to allow the huge bond holdings to mature and fall off of its balance sheet. The fact that this is not being done currently reflects the exquisite degree of caution among Fed policymakers, who don’t want to rock the boat too fast or hard.
Many have wondered about the future of mortgage rates as the Fed begins a cautious exit from the bond markets. Recent history shows mortgages haven’t been especially influenced by changes in the benchmark rate. The last time we saw extremely low interest rates, after the tech bubble burst in the early 2000s, the Fed brought its Fed funds rate down to 1%. It began raising rates by a quarter of a percentage point every three months starting in the summer of 2004, but over the next four months, the 30-year fixed-rate mortgage actually fell from 6.3% to 5.58%. By the time of the last increase in the summer of 2006, mortgage rates were running at 6.68%, just a half percentage point higher than they had been at the previous Fed funds rate low.
Whether rates will be high or low a few years from now has very little to do with what the Fed does this week. It has quite a lot to do with what happens to forces deep inside the economy that are poorly understood and extremely hard to forecast. But the rate rise should be reason for celebration, a sign that the long recession and period of economic uncertainty is finally starting — carefully — to be put in our rear view mirror.
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