Fed Flattens Curve

Today, the Federal Reserve shocked long term interest rates into complying with its policies by announcing that they would start buying long term treasuries. Immediately, the prices of long bonds started soaring, sending the yields crashing down.

So why did the Federal Reserve do this? A problem arose in December when the Federal Reserve ran into the Zero Bound – they couldn’t lower short term interest rates under 0%, but they still wanted lower interest rates generally to “stimulate the economy”. The Federal Reserve has been looking for ways to lower long term interest rates ever since – they’ve finally decided just to start buying long term treasuries which will artificially decrease long term interest rates (for a time).

A few hours before the announcement, Marketwatch was running a story discussing mortgage interest rates. Despite everything the Federal Reserve and the government are trying to do, they hadn’t been able to push long term interest rates down far enough to alleviate the housing crisis. They believe that if mortgage interest rates get low enough that they will be able to stop housing prices from falling farther. Lower interest rates increase “housing affordability” – meaning that banks qualify people to take on even more debt based upon the smaller monthly payment required for lower interest rates.

When short term rates are much lower than long term rates, economists refer to the situation as a “steep yield curve.” So far, banks have benefited from the steepened yield curve – but homeowners haven’t. Bernanke is hoping that he will be able to force the curve to flatten out – but there is only so much he will be able to do. Even if long term treasury yields decline substantially, it is difficult to understand how lenders will be excited to lend money for real estate investments at significantly lower rates. Will anyone really lend Californians money to buy homes at 4%?

The consequences of the Fed’s actions are grave – and they know this. However, with none of their other measures working well enough, they felt it was worth the risk. We already have to stretch our vocabularies to describe the situations we find ourselves in these days. Debt monetization and quantative easing are the up and coming words that we need to research and learn.

After the announcement, the dollar broke down and lost a substantial amount in mere minutes. Let’s hope one of the new words we have to learn isn’t Zimbabwefication.