The Fed wants out, and here’s their plan

Posted on : 12-07-2011 | By : Adam Courtice | In : Mortgage Info Online

Tags: Fed, Fed Wants

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The minutes from the June Fed meeting were released yesterday, revealing a general format for how the Federal Reserve will end and exit all the extraordinary programs (”policy accommodation”) it employed to help push the economy out of the recession.

It’s all about timing

To begin, the Federal Open Market Committee will determine the timing and pace of policy normalization. ( Since adjusting policy as needed is what they do, this seems like it was unnecessary to include in the statement.)

Interest rates will rise

The first step is for the Fed to stop buying additional Treasury debt. Presently, they are reinvesting the proceeds of principal payments on the mortgages and maturing obligations (the Treasury bills, notes and bonds they already hold). When they stop, it means that the market will lose what has been a steady, regular buyer in the market for new debt, which generally serves to keep interest rates a little lower than they would otherwise be.

At the same time (or pretty close to it), the Fed will modify the language it uses to prepare the market for what will be coming in terms of future interest rate changes for the federal funds rate (”…modify its forward guidance on the path of the federal funds rate…”), while also using its power to swap cash held at banks for Treasury debt (”temporary reserve-draining operations”).

This would have the effect of taking cash from banks and holding it for a period of time to keep it out of circulation. Too many uncontrolled dollars floating around the economy makes the Fed’s job of controlling interest rates more difficult.

The fed funds rate will rise

The next step would be to start raising the federal funds rate. This rate is the overnight cost of funds lent between banks; usually, when the fed funds rate is lifted, it causes a corresponding lift in the prime rate, which affects mostly credit card and home equity line of credit users. When interest rate increases come, they will also be accompanied by increases in the interest rate banks are paid to keep their excess reserves parked at the Fed itself, which again serves to keep dollars out of circulation and serves to enforce the “tightening” of monetary policy.

Mortgage interest rates could also rise

Last, but hardly least, the Fed will begin to sell its holdings of mortgage-backed securities, a process that is expected to take a full three to five years to accomplish. It will announce in advance its intentions to sell, and will sell at a pace intended so as not to disturb the markets or cause a disruption in the availability of credit for other areas of the economy.

This might happen, for instance, if these MBS were met with strong appetite by investors, which would tie up cash which would otherwise be used to make loans or purchase other kinds of securities, like corporate bonds, for example. The lack of investors for these bonds or a contracting in the supply of funds for them would drive up interest rates for these borrowers.

We still don’t know when

While the Fed described the road it will travel, it still does not know when the trip will begin (”…the Committee’s discussions of this topic were undertaken as part of prudent planning and did not imply that a move toward such normalization would necessarily begin sometime soon.”) nor how long it will take to get back to normal. (”The Committee is prepared to make adjustments to its exit strategy if necessary in light of economic and financial developments.”)

Our best guess is that the first gentle steps might come at the end of this year, but we’ll need to see a whole lot of economic improvement before then. Some FOMC participants even suggested that additional policy easing might be in play if labor markets don’t improve, which of course would kick these plans even further down the road into 2012.