Fed Prepares to End Mortgage Program

By Neil Irwin
Washington Post Staff Writer
Thursday, September 24, 2009

The economy has "picked up" in recent weeks, Federal Reserve policymakers said Wednesday, as they indicated that the end is within sight for a massive program to support mortgage lending.

But even as the Fed takes another step to unwind one of its unconventional efforts to boost the economy, the central bank remained cautious in its assessment of the recovery, warning that a weak job market could be a drag for some time. The Fed not only left its target interest rate near zero, as was widely expected, but again asserted that the rate will likely remain at "exceptionally low levels" for an extended period.

The decision of the Fed's policymaking committee gives new insight into the central bank's exit strategy in its expansive interventions in the economy over the past year.

The strategy is proceeding on two tracks: Policymakers are addressing a fundamentally weak economy by leaving the federal funds rate, at which banks lend to each other, very low for a long time. But they are removing their less conventional programs as soon as they feel they can do so without disrupting financial markets.

"They're telling us, 'We'll take out some of our facilities, but we're not even close to raising the federal funds rate,' " said John Silvia, chief economist at Wells Fargo.

The stock market, after initially rallying on enthusiasm for the Fed's decision to maintain low interest rates, ended the day down 1 percent, as measured by the Standard & Poor's 500-stock index.

After its two-day meeting, the Federal Open Market Committee said a program to purchase $1.25 trillion worth of mortgage-backed securities issued by firms like Fannie Mae and Freddie Mac will be allowed to expire by the end of March 2010. The move follows the committee's action at its previous meeting to wrap up a program to buy $300 billion in Treasury bonds by the end of October.

Winding down the mortgage program could prove tricky in that the Fed's buying has accounted for a majority of the purchases in that market in recent months. The central bank is betting that by gradually tapering its purchases, private buyers will return to the market and rates won't rise much. If they are wrong, mortgage rates could spike, endangering a budding recovery in the housing market.

The bond market received the Fed's announcement favorably Wednesday, with the gap between rates on mortgage-backed securities and U.S. Treasury bonds little changed. That suggests that investors stand willing to start buying the mortgage securities as the Fed withdraws, which would prevent a major rise in mortgage rates.

"We're starting to see increased activity from private investors, taking the place of public purchases," said Kurt Karl, chief U.S. economist for Swiss Re. "I think we're in good shape unless something surprising happens."

The Fed's policymaking committee found that "economic activity has picked up following its severe downturn," according to the statement announcing its decision. That assessment was better than what the committee offered in August, when it said only that there was evidence that "economic activity is leveling out." The improved outlook is consistent with Chairman Ben S. Bernanke's comment last week that the recession is "very likely over."

Still, there were plenty of caveats to that more upbeat assessment. "Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit," the statement said. It added that businesses are still cutting back on investments and staffing, though at a slower pace than they were before.

Worries about inflation remained remote, as the policymakers viewed price pressure as likely to "remain subdued for some time." But the Fed did emphasize twice in a three-paragraph statement that it views the amount of slack in the economy -- unused productive capacity -- as the key to understanding where inflation is heading.

In other words, Fed leaders think that inflation will stay contained as long as there are vast armies of unemployed workers and the nation's factories are disproportionately idle.

"It could take at least a couple of years before the excess capacity is chewed up," said Sung Won Sohn, an economist at California State University Channel Islands.

The decision was unanimous, continuing a period of unanimity on the committee that dates to March. There had been speculation that one or more presidents of regional Fed banks might dissent, as some have expressed greater eagerness than Bernanke to unwind the Fed's unconventional programs, perhaps even ending the purchases of mortgage-backed securities before the full $1.25 trillion is deployed.

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