Apr262017

How does housing benefit when the federal reserve prints money?

How does housing benefit when the federal reserve prints money?

When the federal reserve prints money to buy mortgage-backed securities, it lowers mortgage rates and allows potential buyers to borrow more money and push house prices higher.

The federal reserve sets policy in meetings of the Federal Open Market Committee (FOMC), a group of bankers. The FOMC sets target interest rates and directs its traders to either buy or sell securities to meet interest rate targets. When the federal reserve buys Treasuries, the price goes up, and interest rates go down. When the federal reserve sells Treasuries, the price goes down, and interest rates go up.

Prior to the financial meltdown in 2008, the federal reserve only bought short-term Treasuries, but in an effort to rescue housing, they began an unprecedented campaign of buying 10-year Treasuries and mortgage-backed securities in order to drive down mortgage interest rates.

It’s important to remember that the federal reserve had never done anything like this before. However, with the member banks of the federal reserve exposed to a $1 trillion in unsecured mortgage debt, stimulating housing to make prices go up was considered essential to save the banking system — or at very least preserve the jobs and bonuses of powerful banking executives.

Printing Money

When the federal reserve buys a Treasury note or a mortgage-backed security, unlike an ordinary bank or citizen, it doesn’t have the money stored in some account it uses to buy. When the federal reserve buys, it merely prints money. That money didn’t exist prior to the federal reserve’s purchase.

There are limits to how much money the federal reserve can print. Ultimately, the total amount of money in circulation represents the total value of goods and services in the economy. If the federal reserve prints too much — and there is always pressure to print free money — the excess causes price inflation.

During the housing bubble, lenders created a large amount of mortgage debt. Ostensibly, this was backed by the “value” they were creating in housing. Unfortunately, since this value was not real, the mortgage debt bloated the money supply and created a false economic boom.

Monetary Deflation from the Housing Bubble

The collapse of the housing bubble caused a great deal of mortgage debt to vanish. When banks make loans that don’t get repaid, and they cannot recover the loan amount through foreclosure and resale of the asset, deflation results. In effect, the losses unprint money. The main reason we didn’t see inflation from the federal reserves endless quantitative easing (fancy term for printing money) was that the new money printed was merely offsetting money destroyed by bank write downs from consumer deleveraging. (Also, some inflation was exported to countries with a currency pegged to the dollar.)

Yields on long-term debt

The federal reserve bought 10-year Treasuries and mortgage-backed securities specifically to lower mortgage interest rates and reflate the housing bubble. Private investors also purchased these securities because despite their low yields, they provided better returns than competing investments.

However, investing in longer-term debt while interest rates were at record lows was characterized as “picking up nickels in front of steamrollers” because the resale value of these instruments plummeted when interest rates began to rise. What investors made in yield they surrendered when values dropped later on.

Investors aren’t stupid. Most know this, so these investors have their finger on the eject button, and the herd is easily spooked. The slightest hint of a move higher in rates causes investor panic, wild selloffs, and short-term spikes in interest rates.

The 2013 spike in mortgage rates was caused by the rumor that the federal reserve might taper off its purchases of mortgage-backed securities. Merely the rumor, not any announcement of a change in policy, caused the interest rate spike.

The 2016 spike in mortgage rates was caused by the impression that Donald Trump’s policies would be inflationary. Bonds sold off causing a rate spike right after Trump’s election, long before he could actually implement any inflationary policies.

After a few weeks of sitting in cash, these investors started looking for investments that provided yield. When none were available, they piled back into longer-duration debt, prices rose, and interest rates fell again. This skittish flow of money in and out of the bond market creates much volatility in rates, and at some point, investors will find superior competing investments, and the money will not flow back into these bonds. When that happens, rates will steadily rise.

Why do we know mortgage interest rates will rise?

Interest rates are near record lows, it’s difficult to imagine they will go anywhere but up. A simple reversion to the mean suggests that much. However, the case for rising rates is anchored in something much more tangible. An astute reader posed the question in the comments recently, “Since the fed has been buying the overwhelming majority of Treasuries and mortgage-backed securities, when they taper off their purchases, won’t there be some effect of the loss of a major buyer of these assets?”

Take away the major buyer of any asset, and prices will likely fall, perhaps a great deal. Remember, falling bond prices mean rising interest rates. Unless some major sovereign power or central bank steps in to take up the slack, prices will fall and interest rates will rise.

Icarus and endless quantitative easing

Rising interest rates hurt the banks by making it more difficult to reflate the housing bubble. It makes life difficult for our government issuing all this debt the federal reserve buys. Rising interest rates make the debt-service payments on the US debt onerous. So why not print money indefinitely?

Printing money is dangerous. The only reason the federal reserve gets away with it now is because investors don’t believe their printing is causing inflation. Realistically, as long as we were still deleveraging and writing down copious amounts of mortgage debt, that was probably true.

Investors satisfy themselves with 2% yields on 10-year Treasuries as long as they believe the currency is losing value at less than 2% per year from printing money. In fact, with monetary deflation caused by debt deleveraging, many investors perceive that real interest rates (those adjusted for inflation) are still quite high. In short, as long as we have deflation, low yielding treasuries are a good investment.

Once consumer deleveraging stops and money is no longer being destroyed, further quantitative easing will be inflationary, and if investors believe inflation will exceed the yield they are getting on long-term debt, they won’t buy it. The lack of buyers causes bond prices to drop and interest rates to rise. This change in belief is was sparked the 2016 selloff after Trump’s election.

Icarus is a character from Greek mythology. He wanted to escape the island of Crete, so his father fashioned him wings made of wax and feathers and instructed him not to fly too close to the sun or the wax would melt and he would crash. Icarus did not heed his father’s warning, and when he flew too high, the wax melted, the feathers fell off, and he crashed back down to earth.

Quantitative easing is much like the flight of Icarus. When the economy got really bad, it was arguably the only way out of our predicament. If they print just the right amount, we can fly to safety. However, if they print too much, if they fly too close to the sun, the melting rays of inflation will cause investors to stop buying bonds, the federal reserve would lose control of long-term rates, and we could have a complete meltdown of the mortgage and housing markets.

This more than theoretical imagining. This is a very real danger.

If the federal reserve prints too much money, inflation expectation will cause investors to abandon the bond market, bond prices would crash, interest rates would spike, nobody could afford today’s house prices at 10% interest rates, and the resulting housing market crash would rival 2008.

This was a very real concern during the post-crash era. Fortunately, the worst fears never materialized — at least not yet.