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Tweaking the Fed's Taper

This is an idea I’ve reported on Varney & Company over the last several weeks. That, when the Federal Reserve scales back its historic purchases of debt starting as expected in September, it only stops buying  U.S. Treasuries, but continues to buy mortgage-backed securities in order to be supportive of the ongoing housing recovery.

Economist Ed Yardeni notes that, in his speech last year, Fed Chairman Ben Bernanke discussed “Large-Scale Asset Purchases” (LSAP). Yardeni, one of the sharpest minds around, points out this is what the head of the central bank said:

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“After nearly four years of experience with LSAPs, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. … Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP ["Operation Twist"], found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.”

So, Bernanke is saying Fed purchases of long-term bonds were successful in driving rates down.

But Yardeni points out a problem: Recently, the 10-year Treasury bond yield rose by 116 basis points from this year’s low of 1.66% on May 2 to 2.82% on Friday. That happened mostly as a result of all the Fed’s chatter about tapering.

So what to do? It seems even the hint of a Fed retreat has caused Treasury bond traders to go berserk. Goldman Sachs is already out in the markets saying the Fed should continue to buy mortgage-backed securities since mortgage-lending standards remain tight in various parts of the country, as opposed to easier standards for commercial real estate.

Mortgage rates hit historic lows last May, and people rushed to refinance. The fear is a mortgage rate spike higher could freeze over refinancing and the housing market, and even cause layoffs at banks.

Others argue the Fed should quit spiking the punch bowl because it’s creating bubbles in certain housing markets.

Northwestern University economists Arvind Krishnamurthy and Annette Vissing-Jorgensen presented fascinating research on this topic at the annual meeting of central bankers in Jackson Hole, Wyo. They suggest the Fed should stop buying Treasuries, start rolling off this government debt as well as older  mortgage-backed securities, BUT keep buying new mortgage-backed securities.

Think about it. The housing market has helped drive consumer confidence higher. Consumer spending is 70% of the market. With part-time jobs now at a record 28 million, those low-paying jobs have driven wages and median household incomes down. The Fed is well aware of these trends, and that’s why it could lean toward buying only mortgage-backed securities when it announces its withdrawal. You heard it here folks.

What do you think?

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