Fed Likely To Continue Buying Mortgage Instruments

Story from the Wall Street Journal

WASHINGTON -- The Federal Reserve, which convenes its policy meeting next week, is likely to stay the course to buy $1.45 trillion in mortgage-linked securities despite potential resistance from a few regional Fed presidents.

Central-bank officials plan to discuss winding down those purchases over the coming months to limit disruption to the market when the buying comes to an end.

Some regional Fed policy makers have suggested the Fed might halt the program before it finishes its purchases of $1.25 trillion in mortgage-backed securities and $200 billion in Fannie Mae and Freddie Mac debt announced in the past year. But they are a small minority across the Fed system.

Top Fed officials believe such a move would tighten overall monetary policy at a time when they still worry about the durability of the economic recovery. The Fed has completed about two-thirds of its purchases, almost $1 trillion worth, and is likely to complete the rest unless prospects for the economy improve radically in the coming months.

At the Federal Open Market Committee's Sept. 22-23 meeting, the central bank's policy makers -- including the 12 regional Fed presidents -- will assess the early signs of improvement now taking shape across the economy. Officials are encouraged by the rebound in financial-market conditions and initial indications that the housing market is pulling out of its deep dive.

But they are hesitant to bank on a strong recovery. The sizable growth expected in the third quarter is due in part to short-term effects such as companies replenishing inventories and the government's "cash for clunkers" auto-rebate program. Higher saving by households is casting doubt on consumer spending. And even the moderate growth that Fed officials expect next year wouldn't be enough to bring down the unemployment rate substantially.

"The economy seems to be brushing itself off and beginning its climb out of the deep hole it's been in," San Francisco Fed President Janet Yellen said in a speech Monday. "But I regret to say that I expect the recovery to be tepid. What's more, the gradual expansion gathering steam will remain vulnerable to shocks."

The economy has so much slack that officials expect core inflation -- excluding food and energy -- to drift lower next year. Barring a surge in commodity prices or inflation expectations, most Fed officials see little reason to raise interest rates from near zero in the first half of next year as futures markets have forecast recently.

The Fed's next key decision is how to wind down its program to buy mortgage-linked securities and to assess its effect on mortgage rates as that occurs. The central bank now accounts for all but a sliver of the market for mortgage-backed securities, crowding out private activity and raising doubts about how the market would function without government involvement.

At their August gathering, some Fed policy makers believed that a "tapering" of those purchases beyond their scheduled conclusion in December "could be helpful in the future as those programs approach completion," according to minutes of the meeting.

Two weeks later, Richmond Fed President Jeffrey Lacker said in a speech that he "will be evaluating carefully whether we need or want the additional stimulus" that purchasing the full announced amount would provide.

But another policy maker, Chicago Fed President Charles Evans, said he expects the Fed to carry out the entire amount of purchases. Other Fed officials share that view, worrying about the Fed breaking from a commitment the market is counting on. The central bank's program has pushed mortgage rates down substantially over the past year, helping to spur the housing market and support the overall economic recovery.

How much mortgage yields rise when the central bank ends its purchases will depend in part on how the Fed communicates its plans and how private investors respond.

Policy makers are considering two main views of how the central bank's involvement influences mortgage rates: by its total stock of mortgage-backed securities, or by the flow of its purchases.

Under the stock view, the fact that the Fed maintains large holdings of mortgage-backed securities is the key factor in keeping mortgage rates down. In that case, how the Fed ends its purchases wouldn't matter.

Under the flow view, the liquidity effect from continuing weekly purchases from the Fed is key to keeping mortgage rates low. Stopping abruptly could push rates higher in the short run.

Tapering the purchases would be a compromise between those views that gives the market time to adjust to the Fed's changing presence. And it would give Fed officials a chance to assess the effect of changing the flow of purchases on mortgage yields.

The Fed expects some increase in mortgage rates, and that alone would be a form of tightening financial conditions. Doing that slowly could help policy makers assess when to start using their other levers -- such as the payment of interest on reserves held by banks at the Fed or the federal-funds rate -- to tighten overall policy.