The Fed – Getting Back to “Normal”

The Fed’s tapering should not be viewed as a reduction in their accommodative monetary policy; rather the Fed is anxious to return to a more normal posture in the financial markets and to regain flexibility of action to respond to future market panics.  Historically (pre QE) an accommodative Fed position in the market would be reflected in a steep positive yield curve. A positive yield curve is made up of lower short term interest rates and higher long term rates. In an effort to rebuild the demand of a devastated housing market; the Fed, through QE, has forced the curve flatter during a period of monetary accommodation resulting in historically low mortgage rates. Recent data does argue that the Fed’s stimulus targeting housing has worked in spite of continued credit tightening by banks unwilling to lend. The current yield curve explains to a large extent bank’s hesitation to lend.  Banks generally borrow short and lend long.  A relatively flat yield curve does not create incentives for banks to lend because spreads are too narrow. Indeed the traditional response to a restrictive money policy is a flat yield curve as the Fed seeks to cool the economy by reducing credit. So, during this recent emergency move described as quantitative easing (QE), the Fed has been working at cross purposes by targeting retail demand for mortgage while reducing incentives for banks to lend. Continue reading