Sunday, April 22, 2012

Will Additional Fed Stimulus Cause Lower Mortgage Rates?

Earlier this week, a colleague of mine wrote a good post on how an additional round of quantitative easing by the fed might affect mortgage rates. For those who don't know quantitative easing is a mechanism by which the Federal Reserve increases the money supply. The Fed does this by creating money out of whole cloth, which it then uses to purchase assets (in this case the Fed will likely purchase treasury bonds). This transfer of cash into the economy is supposed to give banks excess reserves, and this excess is lent out or put into the economy, hopefully stimulating growth.
In a speech earlier today Fed Chairman Ben Bernanke seemed to indicate that economic conditions warrant further quantitative easing by the fed (this would be the second major round of quantitative easing, thus the nickname QE2). Bernanke said:
"Given the Committee's objectives, there would appear-all else being equal-to be a case for further action. However, as I indicated earlier, one of the implications of a low-inflation environment is that policy is more likely to be constrained by the fact that nominal interest rates cannot be reduced below zero. Indeed, the Federal Reserve reduced its target for the federal funds rate to a range of 0 to 25 basis points almost two years ago, in December 2008. Further policy accommodation is certainly possible even with the overnight interest rate at zero, but nonconventional policies have costs and limitations that must be taken into account in judging whether and how aggressively they should be used".
This is not really a surprise to anyone. Analysts and pundits have been expecting a second round of quantitative easing for quite some time now. The economy is growing at a much slower pace than the Fed's growth goal of 2 percent. While some Fed Governors (such as Thomas Hoenig of the Kansas City Fed) are opposed to further QE due to fears of inflation, that viewpoint seems to be the minority.
So the big questions are: will this stimulus work, and what effect will it have on mortgage rates? The second question is the most easily dealt with, so let's start there. Theoretically, additional bond purchases from the Fed should cause mortgage rates to decline. Additional demand for treasury notes created by Fed purchases should cause the prices of these notes to increase. This will cause the yield on these bonds to decrease. Mortgage rates generally follow treasury yields, so if yields decrease, so should mortgage rates. However, we have seen mortgage rates hit all-time lows for the last four weeks. It is entirely possible that QE2 is already baked into the price of bonds, as everyone already expects it to occur. If this is the case, mortgage rates might only move significantly if the size of the stimulus is much greater or smaller than the market expects.
Whether or not QE2 will be successful in stimulating the economy is a more difficult question, and I left my crystal ball at home today. Paul Krugman of the New York Times has suggested that we need -10 trillion worth of QE. This seems unlikely to happen. Opinions on the effectiveness of monetary policy for relieving our current situation vary. Interest rates have been near zero for more than a year, and the economy is still struggling. Only time will tell, but it is entirely possible that the Fed is simply pushing on a string here. The next Federal Reserve meeting occurs November 2-3, so we will know more at that time.

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