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Fed plan may lower rates, but at what cost?
March 19, 2009 / 9:18 PM / 9 years ago

Fed plan may lower rates, but at what cost?

By Burton Frierson - Analysis

<p>The Federal Reserve Building in Washington while the Fed is inside meeting, October 29, 2008. REUTERS/Larry Downing</p>

NEW YORK (Reuters) - Through its control of the printing press the Federal Reserve may be able to push down government bond yields as low as it wants, though it will eventually face a day of reckoning with inflation.

The Federal Reserve said on Wednesday it would buy up to $300 billion in longer-term Treasuries, effectively printing money in order to lower yields and bring down borrowing costs throughout the economy, particularly in the troubled mortgage sector.

Not all analysts agree the plan is a good idea or that it will cure what ails the heavily indebted economy, but many expect it to bring the benchmark 10-year note yield back down to the 50 year lows seen around 2.0 per cent seen last December.

“They can hold them down as low and as long as they want because they can print as much money as they want,” said Marty Mitchell head of government bond trading at Stifel Nicolaus in Baltimore.

“Yields can stay low and probably are headed lower.”

Inflation will ultimately become an issue, Mitchell said, but the more immediate concern was the prospect of a downward deflationary spiral in prices, wages and economic activity.

This means inflation is not on the agenda and will not be for at least a matter of months and possibly a couple of years.

“Inflation is tomorrow’s end game,” Mitchell added. “Right now they’re fighting off a deflationary environment.”

FOUR PERCENT MORTGAGE RATES ?

In the wake of the Fed’s announcement on Wednesday, 10-year yields fell as far as 2.47 percent from near 3.0 percent for the biggest one day fall since the 1987 stockmarket crash, but on Thursday 10-year yields actually rose to 2.59 percent.

Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson & Co. in Seattle, also said the 2.0 percent level on 10-year yields would come into play, but was not sure how long the Fed could hold yields at that level.

“I think their desire is to get conventional mortgage rates down to four percent and I think they’re going to keep buying Treasuries to achieve that level,” Hurley said.

Interest rates on 30-year fixed-rate mortgages fell more than 0.40 percentage point to 4.79 percent on Thursday, according to the Zillow Mortgage Rate Monitor, compiled by real estate website Zillow.com.

The Fed has made clear it wants to support mortgage market, and pushing rates down may indeed help overly indebted home owners switch out of onerous loan terms and into cheaper ones.

Still, it remains to be seen whether credit easing will help an economy suffering from the effects of rampant over borrowing by consumers more broadly.

The Fed may take comfort, though, from the fact that it is not alone, with the Bank of England and the Bank of Japan involved in similar debt-buying endeavors.

CROSSING THE RUBICON

And then, there’s the nagging issue of inflation.

“While we’re not concerned about inflation right now, boy we potentially have a huge problem down the road,” said Hurley. “I don’t think it’s this year or next year’s problem but maybe 2011.”

“We’ve got a huge amount of stimulus and how is the Fed going to unwind all this? I can see a scenario where interest rates go up dramatically, which will hurt the economy. So, it’s a mess.”

It’s not just interest rates that may facing greater volatility. The dollar too might be in for a wild ride if Wednesday’s plunge is any guide.

Against a basket of currencies, the dollar sank 3.0 percent, its largest percentage drop since 1985 .DXY.

This result of the Fed plan may be the biggest concern.

Even though the central bank may have some initial success in depressing rates, analysts worry that monetary policy has passed a point of no return with the printing of money.

“We’ve crossed the Rubicon,” said Howard Simons, strategist at Bianco Research in Chicago. “We have absolutely severed any connection between our dollar and reality. It’s as fast as you can print it right now.”

Additional Reporting by Julie Haviv

Our Standards:The Thomson Reuters Trust Principles.
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