In its statement, the Federal Open Markets Committee (FOMC) left its key interest rate unchanged at a range of 1.0 to 1.25 percent. As signaled in its last statement, the FOMC, beginning in October, will initiate the balance sheet normalization program. The contents of this program are described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.
As discussed previously, traditional monetary policy (changes in the federal funds rate) remains the primary tool used by the FOMC in meeting its statutory mandate of maximum employment and price stability. The FOMC decided to keep the federal funds rate unchanged at a range between 1.0 percent and 1.25 percent, which they believe is accommodative, supportive of its dual goals. In its statement, the FOMC noted that “job gains have remained solid and the unemployment rate has stayed low.” However, “on a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent.”
In response to the Hurricanes Harvey, Irma, and Maria, the FOMC notes that “Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.” Similar to NAHB’s findings, the FOMC noted that “higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.”
Although the FOMC maintained the federal funds rate; beginning in October, it will begin to normalize its balance sheet according to the plans outlined in June. The Fed will begin normalization by decreasing reinvestment of principal payments. This will occur by only making future reinvestments in excess of defined caps. For MBS, this monthly cap will start at $4 billion. The monthly cap will then increase in $4 billion steps in three-month intervals until rising to a $20 billion cap. For U.S. Treasury securities, this monthly cap will start at $6 billion. The monthly cap will then increase in $6 billion steps in three-month intervals until rising to a $30 billion cap. These plans imply that the process will be gradual and predictable, and that balance sheet normalization will shrink the Fed’s balance sheet.
A key concern of the balance sheet normalization process is that interest rates, mortgage rates in particular, could spike dramatically. The figure above shows the historical basis for this concern. In testimony to Congress on May 22, 2013, then FOMC Chairman Ben Bernanke said “If we see continued improvement and we have confidence that that is going to be sustained, then in the next few meetings, we could take a step down in our pace of purchases.” Chairman Bernanke reiterated this view on June 19, 2013 in a press conference. In response, the rate on the 10-year Treasury note rose from 2.03 percent on May 22, 2013 to 2.94 percent on December 19, 2013, although it had already begun to rise. However, the rate on the 3-month Treasury bill did not show significant increase over the same period.
Instead, analyzing the economic components of the 10-Year Treasury note rate, as shown in the figure above, provides some explanation of the “taper tantrum”. While financial markets’ expectations of inflation remained about stable in the months following the Chairman’s statements, the real return on the 10-Year Treasury moved from a negative percentage to a positive one. This move in the expected real return is partially consistent with the important theoretical work asserted by Robert Lucas, Jr. on the non-neutrality of money, that declines in the money supply should increase productivity, however inflation should fall as well.
The rate on a 30-Year fixed rate mortgage includes both the rate on the 10-Year Treasury note and the risk premium associated with mortgage lending. The activities of the GSEs ensures that the mortgage risk premium remains low and steady. However, the figure above explains why the FOMC initially began to purchase MBS and the impact of Chairman Bernanke’s comments on mortgage rates. Between 2007 and November 25, 2008, the date when Federal Reserve announced it would initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae, mortgage rates fell somewhat, but the mortgage risk premium rose dramatically. In response to these and additional purchases, the mortgage risk premium shrank. Second, in response to the taper tantrum the mortgage risk premium rose somewhat but declined over the following weeks. The additional vertical lines on the graph above refer to important monetary policy events in recent years.
This event analysis suggests that, all else remaining the same, the balance sheet unwinding could push mortgage rates up, but not dramatically. More specifically, both a higher real return and, to a smaller degree, a higher mortgage risk premium would be the likely channels pushing up mortgage rates. However, mortgage rates have fallen since the FOMC articulated that normalization was coming “relatively soon”.
The overall path of mortgage rates will also depend on inflation expectations. If expectations of inflation decline, as would flow from money’s non-neutrality and as is expected in the near-term following the latest Consumer Price Index release, then any upward pressure could be offset, but, if inflation expectations rise, say in response to a fiscal policy shock when the labor market is tight, then mortgage rates could move up further. As a result, it is important to note that since an unwinding like this is historic, the outlook for mortgage rate is “uncertain”, as distinct from “risky”. Since the FOMC’s undertaking is unprecedented, it’s difficult to estimate with high confidence all of the potential outcomes and their associated likelihood of materializing.