The Board of Governors of the Federal Reserve System through the Federal Open Market Committee (FOMC) determines short-term interest rates in the U.S. when it sets the overnight rate that banks must pay to each other for borrowing reserves. The FOMC also determines whether the Federal Reserve should adjust the nation’s money supply by either purchasing or selling bonds on the open market. Policy decisions are announced at the end of each meeting, along with a discussion on the reasoning for any changes in the federal funds rate or any other monetary policy measures.
The last meeting of the Fed took place between June 18 and June 19. Following the meeting, the Fed issued a statement announcing that the economy expanded at a moderate pace over the past month and that most sectors on balance had been performing better and inflation expectations remained stable. The Fed opined that fiscal policy is restraining economic growth.
The statement suggested that the Fed continued to believe that inflation over the medium term likely will run at or below its 2 percent objective, so it had no reason to back off of its current loose monetary policy. To that effect the FOMC announced that it would continue to purchase additional bonds at the rate of $85 billion dollars a month, to try to hold down long term interest rates. It also stated that it would continue to keep the target range for the Federal Funds Rate at essentially zero until at least as long as the unemployment rate remains above 6.5 percent. In other words the Federal Reserve stated that it would continue to force interest rates down by printing as much money as possible.
Following this announcement and a subsequent briefing by FOMC Chairman Ben Bernanke, both bond and equity markets plummeted, with yields on longer term notes rising substantially. This suggests that investors believe that interest rates would begin to rise in the near future, and they needed to begin to unwind their positions betting on low interest rates. Mortgage rates also rose substantially continuing a trend that began in the spring. We believe that this is a healthy idea, and that the extended period of low interest rates is coming to an end. The issue will be how quickly will the Federal Reserve’s policy unwind – will it be a controlled rise in rates, or will both inflation and interest rates rise suddenly. The volatility in the market reflects the competing agendas of trying to find yield in an unrealistic interest rate climate against higher investment risk. Our bet has continued to be on the potential for a rapid unwinding of the Fed’s policy and a quick spike in inflation. Currently, most of the money that the Fed has printed has been used to purchase bad assets off of bank balance sheets, with the banks holding the cash in reserve. Since the new money has not actually entered the economy, inflation has been held in check.
But when more money begins to chase a slowly growing supply of goods and services, inflation is inevitable. Higher mortgage rates are the first sign that the market is beginning to move toward a more normal interest rate environment. Once investors begin to expect a return on their assets – either through investing in new production, or by consuming – in inflation genie will emerge quickly.