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THE ROADMAP FOR FEDERAL RESERVE POLICY has been pretty much laid out for the rest of this year and much of the next.
Minutes of the Federal Open Market Committee's April 27-28 meeting released Wednesday showed the majority of the policy-setting panel preferred to wait to begin selling some of the $1.75 trillion in securities cache it amassed over the past year or so until after it has begun to lift its federal-funds rate target.
The latest data moreover suggest a further extension of the "extended period" during which the FOMC has said it expects to keep its target for short-term interest rates "exceptionally low." That's because inflation continues to fall -- perhaps too low -- according to some economists.
And notwithstanding some aberrant anecdotes about housing perking up, the situation remains mostly dire, with signs of a renewed downturn in building and lending activity and further rises in mortgage delinquencies.
Some FOMC members and Fed watchers had suggested the asset sales ought to precede a hike in the FOMC's rate targets. But the minutes indicated most of the panel favored rate hikes first.
"Such an approach would postpone any asset sales until the economic recovery was well established and would maintain short-term interest rates as the Committee's key monetary policy tool," according to the FOMC minutes.
Moreover, the minutes also indicated that the panel preferred to go slow in selling off the agency debt and mortgage-backed securities portion of its portfolio, which comprised the lion's share of the Fed's purchases. The panel figured it would take five years, including mortgage prepayments, to liquidate these holdings.
"Given prepayments and the apparently distant prospect for the first rate hike, this implies a not particularly aggressive pace of asset sales," writes JP Morgan economist Michael Feroli.
The clear lack of inflation pressures at the retail level gives good reason for the Fed to stand pat. The consumer price index unexpectedly fell 0.1% in April, putting its year-on-year gain at 2.2%. The biggest part of the rise in the CPI over the past 12 months came from energy prices, which are up 17%. Now, however, they're in retreat, falling 1.4% last month, which accounted for much of the overall decline.
Excluding food and energy, the so-called core CPI was flat last month and up only 0.9% from a year ago. "This alarmingly fast burst of disinflation," writes High Frequency Economics' chief U.S. economist Ian Shepherdson, "is only a small shock away from outright price declines."
What's so bad about falling prices? Nothing, if wages are rising, so falling prices increase their real spending power. "The risk for the U.S. now, however, is that the combination of extraordinarily high unemployment and falling, or nearly falling, prices will enable employers to squeeze nominal wages down," he points out.
"If wages fall, everything changes," Shepherdson continues. "Falling incomes and fixed liabilities are a recipe for disaster, kicking off a debt-service debt spiral in which people cut spending in order to maintain their repayments. Unfortunately, if sufficient numbers of people take that approach the economy sinks further into the hole, job losses rise again and, in aggregate, people's ability to keep up the payments deteriorates. This a true deflation, and it is very hard to escape; ask Japan."
A new high in mortgage delinquencies despite a rebound in nonfarm payrolls in the first quarter isn't encouraging on that score, he adds. While some may reflect so-called strategic defaults, where homeowners decide it's no longer worthwhile making payments on a mortgage that exceeds the value of the house, it's the overall delinquency rate that counts for banks' balance sheets. "We had hoped the worst was over, but these data suggest that is not yet the case," Ian Shepherdson concludes.
Meantime, there are more signs that housing activity is flagging further without the artificial enhancement of now-ended government tax credits. (See "Housing Begins to Fade Without a Spur,") While housing starts jumped 10.2% in April, just in time to take advantage of the federal largesse of up $8,000 for certain homebuyers, building permits fell a larger 10.7%. That suggests a renewed slowdown in homebuilding.
Mortgage applications also fell again in the latest week despite a further fall in fixed-rate loan costs, according to the Mortgage Bankers Association. Applications for mortgages for purchases collapsed by 27%, the steepest drop since 1997, refinancing applications popped 15% as the 30-year mortgage slid to 4.83%.
With the housing and mortgage sectors -- the key focus of the Fed's securities purchases -- remaining subdued at best, the central bank is unlikely to do anything to raise mortgage rates, such as dumping mortgage-related securities.
Still, with unemployment still near 10% and disinflation possibly turning to deflation, the Fed is likely to stay on hold until 2011 for purely domestic reasons. Add the European credit crisis, which is putting pressure now on interbank lending, and any rate hikes become more distant.
Comments: randall.forsyth@barrons.com
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