Fed Gambles on Low Inflation and a Stable Housing Market

Fed Gambles on Low Inflation and a Stable Housing Market

By Jason Simpkins, Managing Editor, Money Morning

The so-called “exit strategy” has yet to enter the picture.

U.S. Federal Reserve policymakers yesterday (Wednesday) announced that the benchmark Federal Funds rate would remain in its record-low range of 0.00% to 0.25% for an “extended period.” And policymakers also said that the nation’s central bank would continue with its plan to wind down its purchases of agency debt and mortgage-backed securities.

The term “exit strategy” is a financial euphemism for boosting interest rates. By keeping short-term interest rates at what many experts say are artificially low levels, the Fed is betting that inflation will remain subdued in the short and medium-term and that the beleaguered U.S. housing market will be able to stage its recovery without crutches.

The policymaking Federal Open Market Committee (FOMC) “continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” the Board of Governors said in a statement.

But while most members of the committee agreed with the decision, Thomas M. Hoenig, president of Federal Reserve Bank of Kansas City, dissented. Hoenig believed that “economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted,” the Fed statement said.

Hoenig and other critics worry that the Fed’s expansive monetary policy will allow inflation to creep back into the economy. The concern is valid, considering prices are gaining upward momentum along with the U.S. economic rebound.

The Consumer Price Index (CPI) rose 2.7% last month from a year earlier. That’s the largest gain since 2007. Producer prices, meanwhile, rose for the third straight month in December, increasing by 0.2 % and recording their largest year-over-year gain since October 2008.

Like Hoenig, Money Morning Contributing Editor Martin Hutchinson believes the Fed has gone too far and fears that high inflation and a weaker dollar are all but unavoidable.

“The Federal Reserve’s loose monetary policy has put the dollar under duress. The central bank has pumped more than $2 trillion into the U.S. economy since the financial crisis began over two years ago,” Hutchinson wrote in a recent column. “As a result, the dollar tumbled about 20% against the euro in the past year. The Dollar Index – which measures the greenback against the euro and five other currencies – fell to a 15-month low earlier this month.”

The Fed might have considered at least changing its language to telegraph an eventual tightening of monetary policy. However, if Hoenig and others are wrong about inflationary pressures building, raising rates too soon could crush the fragile recovery.

“The Fed wants to sit still until the smoke clears,” Lyle Gramley, a former Fed governor who’s now a senior economic adviser to Potomac Research Group, told Bloomberg News. “To change the ‘extended period’ language would send a signal to markets that a tightening is not far off, and I don’t think the Fed wants to do that.”

Gramley doesn’t expect a rate increase for at least six months, while others don’t believe the Fed will change course until at least November. But by then it will be too late, Hutchinson says.

“With interest rates, the bottom line is that Bernanke is likely to keep them at a low level for far longer than he should,” he said. “When he eventually does start to raise them, he’ll do so only grudgingly, at first, even as inflation races away.”

Indeed, the Fed will have to keep a close eye on inflation, but it also will have to watch for turbulence in the housing sector. The FOMC statement said that the Fed is still in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the policymaking arm of the Fed is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter, March 31.

After a disastrous collapse, the housing market has shown some signs of stability. Home sales surged 28% from September to November. And the Standard & Poor’s/Case-Shiller 20-city home price index released Tuesday inched up 0.2%, achieving a seasonally adjusted reading of 145.49.

However, that boost was driven largely by the Fed’s purchase of mortgage-backed securities and the Obama administration’s $8,000 homebuyers tax credit, which was originally set to expire in November. The tax credit has been extended, but the housing sector will undoubtedly take a hit as the Fed winds up its debt purchases.

In fact, there already were signs of turbulence in December, as existing home sales plunged 17% to a 5.45 million annual rate. That made for the biggest decline since the National Association of Realtors (NAR) began keeping records in 1968.

“Housing is so heavily dependent on the Fed right now,” Sung Won Sohn, former chief economist at Wells Fargo & Co. (NYSE: WFC) and now an economics professor at California State University- Channel Islands, told Bloomberg. “The important thing for them is not to rock the boat and leave themselves plenty of flexibility so that in February and March they can alter their position if they need to.”

The Fed’s purchases have helped reduce mortgage rates by a range of a 25 basis points to 75 basis points, Boston Fed President Eric Rosengren told Bloomberg through Thomas Lavelle, a spokesman.
News and Related Story Links:

Federal Reserve:

Jan. 27 Press Release

Money Morning:

Can Bernanke Tune Out Political Pressure as the FOMC Again Ponders Policy Changes?

Potomac Research Group:

Official Web Site

Money Morning:

Disastrous December Collapse Exposes False Start to Housing Market Rebound


Fed May Take Risk MBS Program End Won’t Hurt Housing