July 11 (Bloomberg) -- When Federal Reserve policy makers start to curb $85 billion in monthly bond buying, possibly before the end of the year, the last thing they want to do is spoil the nascent U.S. housing recovery.
That means the Fed may concentrate first on trimming purchases of Treasuries, while continuing to buy mortgage bonds to keep a lid on interest rates for home loans.
“There is a valid case to slow down Treasury purchases before MBS purchases,” said Roberto Perli, a partner at Cornerstone Macro LP in Washington and a former economist for the Fed’s division of monetary affairs. “The recent sharp increase in mortgage rates poses a threat to the housing recovery, and a continued housing recovery is necessary if the economy is to stay on a more robust trajectory.”
Policy makers led by Fed Chairman Ben S. Bernanke have said in the last two months that the central bank’s mortgage-backed securities program has helped the economy, with Boston Fed President Eric Rosengren urging reduction first in Treasury buying and San Francisco Fed’s John Williams saying mortgage buying was “more powerful.”
Minutes of the Federal Open Market Committee’s June 18-19 meeting, released yesterday, showed about half of the 19 participants wanted to halt bond purchases by year end. At the same time, the minutes showed many Fed officials wanted to see more signs employment is improving before backing a slowing in the pace of the purchases, known as quantitative easing. Bernanke said in a speech hours later that the U.S. economy needs “highly accommodative monetary policy for the foreseeable future.”
Stocks rallied, sending the Standard & Poor’s 500 Index above its record closing level, and bonds advanced on Bernanke’s comments. The S&P 500 gained 1.4 percent to 1,675.02 at the close in New York.
The European Central Bank provided guidance similar to the Fed’s in a statement today saying its commitment to keep interest rates low for an extended period of time uses a “flexible horizon” and will depend on the euro area’s economic performance.
The latest reading on the U.S. labor market showed the number of Americans filing for unemployment benefits unexpectedly increased by 16,000 to a two-month high of 360,000 last week, during a period when applications fluctuate because of automobile plant shutdowns and the Independence Day holiday.
Consumer sentiment climbed for a fourth straight week, reaching the highest level in more than five years as Americans grew more upbeat about their finances, according to the Bloomberg Consumer Comfort Index.
Freddie Mac reported today that the average rate on a 30-year fixed-rate mortgage rose to a two-year high of 4.51 percent in the week ended July 11 from 3.31 percent in November.
Most economists surveyed by Bloomberg on June 19-20 said the initial tapering by the Fed will include a reduction in Treasury purchases as well as mortgage bonds, with 36 percent saying the larger cutback would be in Treasuries, 26 percent saying MBS and 38 percent predicting they would be pared equally.
The FOMC said at its most recent meeting it will continue buying $40 billion in mortgage bonds and $45 billion in Treasuries each month until the labor market “improves substantially.” The committee also pledged to keep the main interest rate near zero so long as the unemployment rate remains above 6.5 percent and the forecast for inflation doesn’t exceed 2.5 percent over one to two years.
Most participants in the June meeting expect that the Fed “would not sell agency mortgage-backed securities” that it already holds as it scales back quantitative easing, according to the minutes. The minutes didn’t reflect any discussion on whether tapering of asset purchases would concentrate first on either Treasuries or mortgage bonds.
Williams told reporters May 16 that mortgage bonds have been a particularly effective tool for Fed stimulus.
“The recovery in home prices has all sorts of beneficial effects,” including “making you feel wealthier,” Williams said. “Many people have responded to their improved finances by spending more on a range of goods and services.”
Rosengren has been more explicit, telling Reuters on April 15 that the Fed should reduce Treasury purchases first.
The importance of housing to the recovery may shape the initial tapering, said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed’s division of monetary affairs from 2004 until 2008.
“The center of the committee would probably like to taper Treasuries first, but it is a committee that likes to try to achieve consensus,” he said. “The motivation would be not to snuff out the rebound in housing. My guess would be they taper both but maybe a bit more on Treasuries.”
Several Fed presidents including Richmond’s Jeffrey Lacker, Philadelphia’s Charles Plosser and Dallas’s Richard Fisher, who have been skeptical of the effectiveness of quantitative easing, have urged that Fed move away from mortgage-backed securities because the holdings amount to targeting a particular industry.
“It is true the Fed thinks the MBS has been quite instrumental in lowering of mortgage rates,” said Millan Mulraine, director of U.S. rates research at TD Securities USA LLC in New York. “The Fed has to weigh that against the fact that over time it wants to move to an all-Treasuries portfolio.”
Some on the FOMC say buying mortgage securities “is a misguided policy and making a credit allocation decision for the Fed,” Mulraine said. “They are going to draw the line between” Treasuries and mortgage bonds.
Housing is helping offset weakness stemming from government spending reductions known as sequestration, which began in March, and a payroll-tax increase at the start of the year. Residential investment could contribute 0.5 percentage point to gross domestic product growth in 2013, New York Fed President William C. Dudley said in April.
Applications to build one-family homes increased to a 622,000 annualized pace in May, the fastest since May 2008, the Commerce Department reported June 18. Home prices in the 12 months through April rose 12.1 percent, the most in more than seven years, the S&P/Case-Shiller index showed June 25.
At first, higher mortgage rates “stimulate demand, because some buyers who are currently hesitating or procrastinating will feel that they had better buy now,” said Brad Hunter, Palm Beach Gardens, Florida-based chief economist for housing research firm Metrostudy. As rates rise further, people may buy “either a smaller home or a home in a more remote location” and builders’ price increases could be limited, he said.
Single-family housing starts are likely to rise 18 percent to a 632,000 pace in 2013 from a year earlier, and by another 26 percent to 796,000 in 2014, said Hunter.
Atlanta homebuilder FrontDoor Communities plans to double its construction to 100 homes valued at $40 million this year, and double that again in 2014, said Chief Executive Officer Terry Russell. The company is building in Naples and Orlando, Florida, Charleston, South Carolina, and Atlanta.
“We are in a full recovery, no doubt about it,” he said. “You are seeing good pent-up demand from people who were on the sidelines for five years. I think the industry has got three good years in front of it. Some people would say five.”
Recent strength in the housing market as well as the commitment not to sell MBS may push the Fed to divide its tapering, said Nathan Sheets, former global head of the Fed’s international-finance division and now global head of international economics at Citigroup in New York.
“The housing market seems red hot” and Fed policy makers could question whether the rebound needs further fuel, he said. Still, the mix probably hasn’t been nailed down. “The decision regarding composition of asset purchases will very much be determined by the economic conditions prevailing at the time, particularly the performance of the housing market.”
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