The Federal Reserve governor made statements Friday that left the markets wondering if the Fed will drastically tighten interest rates when the time comes, instead of gradually increasing them.

Even though Fed Governor Kevin Warsh voted Wednesday along with the unanimous Federal Open Market Committee decision to keep the fed funds rate at “exceptionally low levels …for an extended period”, his comments in a speech yesterday to an international bankers convention in Chicago show he can conceive of the need for quick action in the future.

“The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it.”

He added in a Wall Street Journal opinion piece Friday that, “prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary.’

His Chicago speech echoed such thoughts that the Fed might need to start fighting inflation with rate hikes even before the economy fully recovers.

“If policymakers insist on waiting until the level of real activity [GDP] has plainly and substantially returned to normal-and the economy has returned to self-sustaining trend growth-they will almost certainly have waited too long.”

I doubt that Warsh was speaking on behalf of all the Fed board members in his remarks and writing, but if any of his colleagues share his opinions, we may see mortgage interest rates jumping up much sooner and more significantly than many economists have been predicting.

Since the housing market went belly-up and took Wall Street down with it, the Federal Reserve has been doing all it can to bail out the industry and provide liquidity in the system. The buying up of U.S. Treasuries and government-backed mortgage backed securities (MBS) has been the Fed’s focus.

But as the housing market has started to show signs of life again, the Fed has announced plans to slow down its purchases of Treasuries. It seems to be considering a similar plan with mortgage debt.

“I think something similar might be possible for MBS, but no decision has been made,” said St. Louis Federal Reserve Bank President James Bullard in Little Rock, Arkansas on Thursday. “I think we agreed that on the Treasuries we’d do the tapering thing and see how it works. We can decide some time during the fall how we want to do the MBS.”

And Richmond Fed President Jeffrey Lacker said Thursday in Danville, Virginia:

“I will be evaluating carefully whether we need or want the additional stimulus that purchasing the full amount authorized under our agency mortgage-backed securities purchase program would provide.”

Originally the Fed was prepared to buy up to $1.25 trillion of MBS, but has spent just over $792 billion so far of securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae.

Some people are excited about the possibility of an early exit strategy for the Fed, saying it will open the door for private investors to take over again. Others are not sure the markets are ready for the pullout.
For example Larry Doyle, on the Wall Street Pit blog says:

While Fed governor Lacker would maintain that the Fed may slow its purchasing of MBS because the economy has improved and continues to improve, I would beg to differ. Home sales are rebounding, but delinquencies and foreclosures are running at record pace. Those statistics, in my opinion, continue to cast dark clouds on our housing landscape.

He also predicts that mortgage rates will move higher as a result, probably in the range of 0.50 percent to 0.75 percent, a move that could put a serious damper on the recent flow of home purchase activity.

The Federal Reserve’s Federal Open Market Committee meets again this Tuesday and Wednesday to decide the fate of its target interest rate, currently set at the range of zero to 0.25 percent. There is very little concern that the Fed will raise its rates this week, as the economy continues to teeter. Here’s what committee members have been saying recently according to Reuters:

• NEW YORK FED PRESIDENT WILLIAM DUDLEY, JULY 29:

 ”Credit availability will be constrained for some time to come, and this will serve to limit the pace of the recovery. “

• SAN FRANCISCO FED PRESIDENT JANET YELLEN, JULY 28:

 ”We glimpse the first solid signs that economic growth may be poised to resume. Indeed, I expect that to happen some time this year … I can assure you that we will act decisively and appropriately to tighten the stance of monetary policy and maintain price stability.”

•  FED CHAIRMAN BEN BERNANKE, JULY 21:

“Accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”

• ATLANTA FED PRESIDENT DENNIS LOCKHART, JULY 20:

“The recovery will be weak because the economy must make structural adjustments before the healthiest possible rate of growth can be achieved. While this adjustment process is going on in the medium term, I believe inflation and deflation are roughly equal risks and require careful monitoring.”

So will a decision to do nothing affect mortgage interest rates this week? It just might, based on the Fed’s meeting comments.  If the group says it is worried about inflation, rates could rise. If it seems pessimistic about the economy’s next six weeks, rates might drop.

Recent comments from top Federal Reserve Officials are making it clear they are not yet worried about inflation and they certainly expect to leave their target interest rate alone for quite awhile.

Atlanta Federal Reserve President Dennis Lockhart, in a speech before the Rotary Club of Nashville, said:

“Certainly we have low interest rates today…I would expect that to continue for some time.”

He was also upbeat about the coming recovery of the markets.

“The economy is stabilizing and recovery will begin in the second half [of this year].” However, the rebound “will be weak compared with historic recoveries from recession…current economic conditions are mixed at best.”

He summed up his position by saying “nothing in the incoming data has altered our view that the economy is nearing a bottom and will soon begin a very slow recovery.”

Fed Chairman Ben Bernanke said in the Wall Street Journal today that:

“Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero… My colleagues and I believe that accommodative policies will likely be warranted for an extended period.”

So we probably won’t see mortgage rates rising much in the near future due to Federal Reserve actions. That doesn’t mean that they can’t or won’t climb. Any increase will be simply a result of Treasury yields and market consensus on the state of the economy.

The Federal Reserve decided to keep its benchmark interest rate at is current 0 to 0.25 percent range for the coming six weeks, and long-term mortgage rates posted little movement this week as well, according to mortgage financier Freddie Mac Thursday.

Average rates on 30-yaer fixed rate loans inched up to 5.42 percent, excluding points, during the week ended June 25, from 5.38 percent the week before.  Freddie’s VP and chief economist Frank Nothaft explained that “mixed economic reports” were the cause for the timid rate movement. He cited an increase in existing home sales contrasted by a dip in new home sales and national median prices.
Meanwhile, during its bi-monthly meeting the Fed held its rate steady as risks of deflation have dropped and many other pieces of the economy seem to be falling back into place.

The Fed is still plan to pump billions of dollars into buying Treasury bonds and toxic mortgage-backed securities, but have started to slow down the rate of their purchases. The immediate result seemed to be a rise in mortgage rates, and some think that could stymie the economy from recovering soon.  From Fed Chairman Ben Bernanke’s recent comments, it sounds like inflation is the bigger issue for the central bankers.

“The key issue here is can we unwind this money creation and low interest rates in time to head off inflation when the economy begins to recover?” Bernanke said in remarks before the House Oversight and Government Reform Committee. “We have all the tools we need to do that. We believe we can do that. We will certainly remove that stimulus in time, and we are committed to price stability and we will make sure that it happens.”

After jumping to a seven-month high, rates on long-term mortgage rates dropped back down in the latest week. According to mortgage giant Freddie Mac, during the week ended June 18, 2009, the average rate dropped to 5.38 percent, excluding points, from 5.59 percent the week before, and down from 6.42 percent one year ago.

Why did rates fall? Freddie Mac credited slowed inflation growth for the declining mortgage rates. Many on Wall Street believed inflation would rise by more than it did in May. Most dramatically, producer prices dropped by 5.0 percent from the previous year, the biggest decrease since 1950.

Based on all the recent reports, Frank Nothaft, Freddie Mac vice president and chief economist commented, “It’s still too early to tell whether the decline in housing market activity has hit bottom yet.”
Meanwhile, in an interview on CNBC today, Forbes CEO Steve Forbes blamed the Federal Reserve for the current housing market troubles. As quoted on the dailyfinance.com blog, Forbes said he thinks the Fed “should announce first they’re not going to buy any more Treasury securities. Cash in the banking system is not the problem, the problem is that parts of the credit economy are still not working.” What the Fed should do, he added, is to aggressively buy up mortgage-backed securities as well as packages of credit car, car, and other consumer credit loans.

Forbes also decried the Obama administration’s decision to give the Fed greater regulatory powers over the country’s financial institutions.

“In terms of regulation,” he said, “it is a bit ironic they’re still going to put new powers in the Federal Reserve, which is an agency that, one, didn’t exercise proper oversight over the banking system that it had already under its purview and [two,] its lousy monetary policy in 2003 and 2004, when it printed all this excess money, made the bubble possible.”
Amen.

Market indicators are pointing to an earlier economic recovery from the current recession, perhaps even before the end of 2009, according to statements Monday from Federal Reserve Vice Chairman Donald Kohn.

“The crosscurrents in the recent data and a bit more favorable financial news of late stand in contrast to the uniformly bleak picture of a few months ago,” Kohn said during a speech to the University of Delaware. He added that recent developments “may be an early indication that conditions are falling into place for real GDP to decline at a slower rate in the second quarter and to stabilize later this year.”

Kohn pointed to reports of home sales and new home starts starting to bottom out and even move upward again, and consumer spending leveling out during the first quarter of 2009 as indications that the recession may be over soon.

And while he did comment that the current economic downturn will probably be one of the deepest and longest since World War Two, he also saw plenty of reasons to be optimistic. “I don’t think it is premature to start to ponder the shape that a recovery — when it occurs — would be likely to take.”

Kohn warned that the recovery is not likely to be quick and dramatic, but to take place gradually, especially if Americans continue to save instead of spend until they feel more confidence in the market.

As things start to pick up again, the risk of inflation will grow, requiring the Fed to step in and adjust its spending and interest rate policies, which, Kohn assured the crowd, the Federal Reserve is fully prepared to do.

“We are firmly committed to acting in a way that preserves price stability, and we believe we have the tools to absorb reserves and raise interest rates when needed,” he said.

The U.S. economy and mortgage markets will most likely begin to recover by the beginning of next year, according to statements from Federal Reserve Chairman Ben Bernanke Sunday.

“We’ll see the recession coming to an end probably this year,” Bernanke said during an interview with on the CBS “60 Minutes” program. “We’ll see recovery beginning next year.”

He mentioned that the key to an economic bounce back will be revamping the financial markets.

“Until we get that stabilized and working normally, we’re not going to see recovery, but we do have a plan. We’re working on it,” he said.

The current year will be one of moderating decline, according to Bernanke, with the downward trends bottoming out before 2010. This means unemployment may continue to rise in 2009 but not by such dramatic figures as in the past several months.

Bernanke has been the Chairman of the Fed since 2006 when he took over the reigns from Alan Greenspan. Bernanke has taken a lot of flack in the past year for the Fed bailout actions on behalf of failing U.S. banksand lenders.

“There were many people who said, ‘Let them fail.’ You know, ‘It’s not a problem, the markets will take care of it.’ And I think I knew better than that,” Bernanke said, claiming that to let them fail would have caused system wide chaos.

And while he sympathizes with the many upset Americans over the bailout last year of insurance company American International Group (AIG), he defended the action as necessary.

“Of all the events and all of the things we’ve done in the last 18 months, the — the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG,” Bernanke said. “Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong, we had a situation where the failure of that company would have brought down the financial system.”

His interview did end on a positive note though. “I just have every confidence that as we get through this crisis, that our economy will begin to grow again, and it will remain — the most powerful and dynamic economy in the world.”

Speaking to the National Association for Business Economics on Monday, the President of the Richmond Federal Reserve Bank expressed his fears about the Fed’s recent and current emergency financial aid actions. Specifically, President Jeffrey Lacker mentioned how the Fed may have opened its doors to unwanted political pressures by stepping in last year to provide private corporations with capital to keep the markets moving.

“Using the Fed’s balance sheet is at times the path of least resistance, because it allows government lending to circumvent the congressional approval process,” Lacker said.

“This risks entangling the Fed in attempts to influence credit allocation, thereby exposing monetary policy to political pressure,” he told the Association.

Lacker also underscored the risks associated with the inevitability of cutting the funding to these struggling banks and lenders.

“At some point in the future, the Fed will need to withdraw monetary stimulus to prevent a resurgence of inflation when the economy begins to recover,” he said.

“That time could arrive before credit markets are deemed to be fully enough ‘healed’… If monetary policy and credit programs remain tied together, as they currently are, we risk having to terminate a credit program abruptly, or else compromise on our inflation objective,” Lacker said.

At the past meeting of the Federal Open Market Committee, Lacker, a voting member of the board this year, dissented against the Fed’s decision to continue to spend billions of government money on propping up failing financial institutions. His solution was to provide more market liquidity through the purchase of more U.S. Treasury securities.

In his Monday speech, Lacker called on the Fed to let the U.S. Treasury Department take on the lending role, as it is always required to have official approval from Congress. Letting the Treasury take over would, according to Lacker, allow the Federal Reserve to maintain its long-time held and treasured independence from legislation.

A joint effort by the Federal Reserve and the U.S. Treasury Department, announced Tuesday, has produced the latest in a string of government-funded bailout plans to jump start the economy.

“The financial markets are not working as we’d like them to work … and this is an effort to address that situation,” said Treasury Secretary Henry Paulson in a press conference.

The new package calls for an additional $800 billion dollars to be made available to indirectly help more businesses, consumers, and homeowners to get the loans they need.

Past financial “rescue” plans have not yet had the desired economic impact of increased lending as investors have stayed on the sidelines making it difficult for companies to sell mortgage loan debt and other consumer debts.

“This lack of affordable consumer credit undermines consumer spending and, as a result, weakens our economy,” Paulson said.

Speaking of the initial failure of other bailout programs, Paulson added, “I wish, and I know everybody wishes [for] one piece of legislation, and then magically, the credit markets would unfreeze,” he said. “That’s not the type of situation we’re dealing with.”

At least $200 billion of the allocated funds, via the Federal Reserve bank of New York, will be directed at providing more liquidity to securities-backed investors who buy up consumer debt like credit card balances, car and student loan debt.

The Fed also announced its decision to buy as much as $500 billion of Fannie Mae, Freddie Mac, and Ginnie Mae mortgage-backed securities (MBS). Additionally, it will purchase $100 billion in direct mortgage loans from the government-sponsored home loan giants.

According to the Fed, this plan will “reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”

The money for these new pricey programs will be generated from not from taxpayer funds but from an increase in government reserves, or the creation of new money.