Interest Rate Focus Resumes

by Dr. Lynn Reaser

Amid deliberations in Europe over Greece and negotiations in Washington over financial reform, the Federal Reserve will meet this week to ponder monetary policy.  With a balance sheet of $2.3 trillion, the “exit” strategy from policies adopted to prevent a financial collapse are likely to be just as difficult as the initial “fix-in” strategy.

The Fed ended its purchase program of $1.25 trillion of mortgage-backed securities on March 31 as scheduled.  Rates on 30-year fixed-rate mortgages have edged up slightly to an average of 5.12% so far in April from a March average of 4.97%, but the increase appears to have reflected the general rise in interest rates rather than the Fed’s decision.  The difference between mortgage rates and the yield on 10-year Treasury notes has remained low at around 125 basis points (1.25 percentage points.)  This contrasts to a spread of nearly 300 basis points at the peak of the mortgage crisis in 2008 and is still below a more typical spread of around 160 basis points.  The Fed has talked about selling some of its mortgage portfolio.  A greater impact on mortgage rates can be expected when that occurs.

Meanwhile, inflation expectations in the bond market remain contained but have moved higher.  A comparison of yields on 5-year Treasury notes and Treasury Inflation-Protected Securities (TIPS) shows that investors expect inflation to average about 1.9% over the next five years.  That is still below the Fed’s inflation target of around 1.5% to 2.0%, but does represent an increase over the 1.1% inflation rate embedded in last year’s market.

Monetary policymakers can take comfort that mortgage rates have not yet moved substantially higher, but they may start to begin to worry if inflation expectations start to move above 2.0%.  Life at the Fed and in the bond market will remain challenging.


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