by Dick Lepre
View these articles and more at
“Viewpoint: Why Housing Prices Are Rising,”
“Viewpoint: Lessons from
Lehman Brothers 10 Years Later,”
“The Bond Market as Crystal Ball,”
inflation in goods prices because wage inflation is
“sticky.” Wages do not decline to any significant extent
when unemployment gets higher.
Unsustainable fiscal policy
Since mortgage rates tend to track with the 10-year
Treasury yield, the ability of the Fed to affect mortgage
rates comes down to how the actions and words of the
Fed affect investors buying and selling of 10-year Treasury debt. Forecasting how markets will react in the
short run to fundamentals, other news or word from
the Fed has one inherent risk that gets little discussion.
On any given day, that vast amount of Treasury debt
is not traded.
The small portion of Treasury debt that is traded is
not traded by big players who buy and hold, but more
so by smaller players who intend to buy and sell fairly
quickly. It is more difficult to forecast how these people will act or react. In the longer run, it is the investors
who make the market.
Starting in June 2004, the Fed raised the federal
funds rate 17 times in two years, going from 1 percent to
5 percent. In June 2004, the average 30-year mortgage rate per Freddie Mac was 6. 29 percent. At the
end of 2006, the average 30-year mortgage rate was
6. 14 percent. The correlation at that time between the
federal funds rate and mortgage rates was close to
zero. Over the last 20 years, the federal funds rate and
the average 30-year fixed rate mortgage have differed
by as little as 0.50 percent and as much as 5. 25 percent.
The ability of the Fed to affect mortgage rates
through federal funds policy is very small. In fact, many
overestimate the ability of the Fed to affect the economy in a major way. The underlying reason is that what
has long-term effects on the economy is not monetary
policy as set by the Fed, but rather unsustainable fiscal
policy, which is managed by Congress and the White
House. If we are going to consistently add $1 trillion to
the national debt every year, then monetary policy is
essentially an afterthought.
Longer-term interest rates are all about inflation or,
more precisely, the perception of inflation. Price inflation is created either by increased demand or lower
supply. The most striking thing about the U.S. economy is that despite many years of near-zero rates and
the enormous increase in money supply, we still have
seen only meager GDP growth. First-quarter 2018 GDP
figures showed that consumer spending on goods
actually fell. This is unlikely to translate into higher
prices and inflation. n
In November 2002, then Fed Gov. Ben Bernanke,
who later became the Fed chairman, expressed this
concern when he claimed that the major danger facing
the U. S. economy was deflation. Deflation is the enemy
of those in debt.
In the current economic cycle, the Fed’s message is
as follows: “With unemployment this low, we are really
concerned about inflation.” That outlook may fit with
the traditional notion that once the unemployment
rate falls below a certain level, wage inflation, and consequently price inflation, is inevitable. The fact is, however, that is not happening.
The April 2018 U.S. Bureau of Labor Statistics Employment Situation Report showed 3. 9 percent unemployment and an average hourly wage increase of
4 cents. A decade ago, it was common economic wisdom that an unemployment below 6 percent would
spark inflation. Wage inflation is more serious than
<<Fed continued from Page 120 “If we are going to consistently add
$1 trillion to the national debt every
year, then monetary policy is an
deployed as a bank makes loans. The QE actions after
the Great Recession increased excess reserves from
$1.87 billion in August 2008 to $2.7 trillion in August
2014 — an astonishing 1,400 percent increase.
Unfortunately, just as that $2.7 trillion was being
made available to lend, the Consumer Financial Protection Bureau (CFPB) created regulatory concern among
banks, which had the effect of discouraging lending.
This enormous increase in money supply coupled with
years of a near-zero federal funds rate was intended
to stimulate economic growth. While unemployment
has dropped, what is still of concern is that gross
domestic product (GDP) growth has been modest.
Average annual GDP growth has bumped around
at an average of 2 percent since the Great Recession.
In order to be able to generate enough tax revenue
to get deficits under control, the U.S. arguably needs
closer to 4 percent GDP growth.
The Federal Open Market Committee (FOMC) consists
of the seven members of the Federal Reserve Board
and five presidents of the Federal Reserve Bank including the one in New York. The FOMC dictates the target
for the federal funds rate, which is the rate at which
banks lend excess reserve balances to other banks on
an overnight basis.
Whenever the Fed adjusts the federal funds rate,
banks change their prime lending rate accordingly.
The primary direct effect on mortgages from these
adjustments is on some adjustable rate mortgages
that are pegged to that prime rate. For the most part,
the mortgage products impacted by changes in the
prime rate are home equity lines of credit.
Changes in the federal funds rate and prime rate
affect auto-loan rates and credit card rates far more
directly than they affect mortgage rates.
More importantly, the FOMC reports and the speeches
given by Fed governors make rather clear what Fed
policy is regarding rates.
The Fed is in a rate-hiking mode. With the federal
funds rate now at a historic low, there is little room to
lower rates when the next recession happens. The Fed
is raising the federal funds rate now to create space for
it to be lowered again in the next economic downturn.
The words of the Fed and media coverage of Fed
announcements tend to focus on the need to control
inflation, but this misses what may be the Fed’s biggest fear: deflation. To understand this, look at mortgage debt. If you have a fixed-rate 30-year mortgage,
your payment is fixed for the next 30 years.
In an inflationary environment, your mortgage payment will be less of an economic burden in the future,
given the payment remains fixed, even as the relative
value of the dollar decreases with inflation. Suppose we
had deflation in the value of the money instead. That
would have the opposite impact by putting downward
pressure on prices and wages and thereby making the
borrower’s mortgage payment more expensive in the
future, relative to today.
This is precisely the situation that the nation’s biggest debtor — the Treasury Department — is in today.
These poor folks are more than $21 trillion in the hole
(our national debt), and deflation would make that
$21 trillion in red ink even more painful as prices,
wages and tax receipts decrease.