Fannie, Freddie move fails to upend Fed ideas

CHICAGO (Reuters) - The government takeover of mortgage giants Fannie Mae and Freddie Mac failed to shake the view that a fragile economy will prevent the Federal Reserve from raising benchmark interest rates until far into 2009.

The move to provide federal backing for the country's two biggest mortgage finance companies holds the potential to unfreeze the credit markets and get banks lending again.

On Thursday, San Francisco Fed President Janet Yellen delivered a gloomy economic economy focused on a vicious cycle in the housing and credit markets that threatens to drag down growth -- possibly even forcing the Fed to cut rates again.

Instead, the government's commitment to back the mortgage giants could break that vicious cycle and tilt U.S. growth upwards again, ensuring that the Fed breaks its current policy stalemate with a rate hike, not a cut.

In response to the Fannie and Freddie bailout, home mortgage rates fell sharply on Monday and major U.S. share indices surged as investors bet that the housing sector was in for a shot in the arm.

Over time, "local housing markets will no longer be threatened by a flood of foreclosures and will be able to return to normal functioning," said Andrew Jakabovics, analyst at the Center for American Progress, a Washington-based think-tank.

NO LASTING SOLUTION

But many analysts said while the takeover alleviates the potential for a severe economic shock that seemed to be brewing in recent days, it is not a lasting solution.

"The housing problem has not gone away and there remains the potential for adverse feedback loops where problems in the economy feed back to the financial sector and vice versa," said Tony Crescenzi, chief bond market strategist with Miller Tabak & Co.

Above all, it will take time to assess how the Treasury's move plays out in mortgage offices across Main Street America.

"Whether banks start to churn out more mortgages and sell them to the agencies is yet to be seen, as some may be more concerned with preserving balance sheet health and in doing so keep lending standards very tight," Rudy Narvas, analyst at 4CAST Ltd in New York.

Until then, prospects for Fed policy will likely be dictated by the kind of economic malaise apparent in Friday's August payrolls report, with its eighth consecutive monthly decline in jobs and jump in the unemployment rate.

And with market-based inflation expectations off the boil since early July and in some instances at multi-year lows, the Fed certainly has time on its side.

Derivative contracts that reflect sentiment toward Fed interest rate moves showed prospects for rate hikes rose only marginally on Monday.

Prospects for a rate increase by the end of 2008 rose to a slim 8 percent from zero on Friday. The first hike in a potential tightening cycle is not fully priced until the June 2009 Federal Open Market Committee meeting -- several lifetimes away in financial market terms.

Analysts said the Fannie/Freddie bailout contains no guarantee that the flow of bank lending will increase enough to unclog the financial markets' stopped-up "plumbing" and transmit the Fed's lower rates to a grateful public.

"The public takeover of U.S. mortgage markets over the weekend is unlikely to be a 'magic bullet' that will make all the growing economic and financial pain go away," said Rory Robertson, interest rate strategist at Macquarie Bank in Sydney.

"Highly geared firms and households are 'hunkering down,' trying to economize on spending, sell 'non-core' assets, pay back debt and build cash reserves to survive any worst-case credit-crunch scenario ... this hunkering down reinforces the trend towards economic weakness," Robertson said.