Last updated: September 06. 2013 7:51PM - 45 Views

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Apparently never believing themselves incapable of providing much-needed medicine for an ailing economy, Federal Reserve officials acted last week to reinvigorate lending activities in the U.S. In a move dubbed “operation twist” the Fed will attempt to bring down longer-term interest rates while possibly slightly increasing short-term interest rates.

How do they intend to do this? According to their policy statement from last Wednesday, “…the Committee intends to purchase, by the end of June, 2012, $400 of Treasury securities with remaining maturities of 6 to 30 years and sell an equal amount…with remaining maturities of 3 years or less.” As well, the Fed intends to take the principal payments from maturing Fannie and Freddie mortgage backed securities (MBS) it owns and buy more of the same. In all of this the Fed wants to reduce longer-term interest rates and help facilitate a better functioning mortgage market, given the severe problems that persist in the housing sector.

And what may be the possible effectiveness of such a policy stance over time? Of course, such things are always difficult to predict, but a not-unlikely answer is “little-to-none.”

Let’s think about this logically. To start, long-term mortgage rates are already at rock-bottom levels, with the average 30 year fixed rate loan at just 4.09 percent in the U.S. Suppose the rate were to drop a few basis points (with a basis point being one-hundredth of a percentage point), perhaps penetrating 4.00 percent and going down toward 3.90 percent.

A central issue becomes how much of a change in the quantity of mortgages demanded will this action produce? In economic theory this involves something called “price elasticity of demand.” On the lower price-point segment of a demand curve where price is already relatively low — in this case, the price of borrowed money is an interest rate — theory says that demand is relatively “inelastic,” which means that changes in the price of 30 year fixed rate mortgages will elicit few added mortgage loans desired on the part of borrowers. After all, just how many potential homebuyers are consciously waiting for super-low interest rates to fall just a bit more? Most probably, very few.

As well, consider this issue (slightly lower long-term interest rates) from the lender’s perspective. If the Fed is actually able to force long rates a bit lower, will this make significantly more borrowers better risks? Keep in mind, if inflation heats up over time due to past Fed monetary excesses, the “real” return to the financial institution (or the price to the holder of MBS) will fall and they will take a punch on the financial chin. And with huge numbers of borrowers already underwater in their mortgages, will this do anything to lead to more refinancing and free up consumer dollars for other purchases? Not likely.

Moving beyond just the mortgage sector, one has to wonder exactly who will be inspired to borrow funds. While businesses may be identified as a possibility, medium and large corporations are already sitting on some $2 trillion in cash or cash-like equivalents. This being the case, lower interest rates and increased liquidity from the Fed actions will likely do little-to-nothing to stimulate business loan demand.

Who comes out a winner in all of this? It’s hard to pinpoint, but the biggest winner could be those holding (and wanting to unload) Fannie and Freddie MBS. And who comes to mind as holders of such assets? Financial institutions such as banks, which might still have huge quantities of such holdings on their books from the market crash in such financial assets from a few years ago when the mortgage mess began to unfold. So, the Fed will ride to the rescue yet again in the name of stimulating the economy, buy up unwanted MBS at or near face value, and allow financial institutions to the park the added funds in their excess reserves, which currently obtain a modest yield of 0.25 percent from the Fed. All-in-all, a pretty good deal for impacted banks.

So, the Fed’s desire to facilitate economic growth via lower interest rates and greater lending are potentially short-circuited at each step along the way. And if financial market participants begin to fear higher inflation from these misguided actions, a boomerang effect could ensue (sometimes called a Fisher effect) and actually work to drive up long term interest rates via higher inflation expectations.

Given this, perhaps the Fed’s latest policy actions ought to be renamed “operation twisted logic.”

Dr. James Newton serves as chief economic advisor to Commerce National Bank and is an auxiliary faculty member in economics and statistics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not necessarily reflect those of Commerce National Bank or OSU-Marion/Newark.

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