Yellen's Challenge

The task for the new Fed chairman will be to taper quickly enough to avoid a boost in inflation that could bring higher rates--but not so soon as to weaken the housing recovery.

Mortgage Banking

January 2014

By Robert Stowe England

The first woman to serve as chairman of the Board of Governors of the Federal Reserve System may face one of the toughest assignments since the central bank’s creation just over 100 years ago, in 1913.

Janet Yellen, who is expected to take the helm as chairman of the Fed in February, will execute the central bank’s exit strategy out of its monthly purchases of $45 billion in Treasuries and $40 billion in agency mortgage-backed securities (MBS). She will be in charge as the central bank ultimately deals with the disposition of an accumulated $3.631 trillion in bonds (as of November 2012) acquired through three iterations of the quantitative easing (QE) program.

In December the Fed announced it would begin to taper its monthly purchases this month by $10 billion, with $5 billion less in Treasuries and $5 billion less in agency MBS.

Yellen, who served as vice chairman since 2010, left little doubt that she was as favorably disposed to the QE program as outgoing Fed Chairman Ben Bernanke--and possibly more so.

“We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession,” Yellen said in testimony before the Senate Committee on Banking, Housing and Urban Affairs on Nov. 14.

Her message could not be clearer. Continued high unemployment and low inflation point to the need for continued stimulus with no inflation on the horizon to compel any sort of monetary tightening. “I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy,” she testified.

Yellen, born in 1946 in Brooklyn, New York, attended Fort Hamilton High School, where she was named the “class scholar.” After earning an undergraduate degree at Brown University, she went on to Yale University where she earned a Ph.D. in economics. She studied under Nobel laureate James Tobin, a Keynesian advocate for government intervention to mitigate recessions, a man she has named her intellectual hero.

In 1977 Yellen went to work as an economist with the Board of Governors of the Federal Reserve System, where she met and married fellow economist George A. Akerlof. The two economists collaborated on research and after Yellen married Akerlof, she followed him to lecture at the London School of Economics. They came back to the U.S. to teach at the University of California at Berkeley.

Yellen returned to Washington in 1994 to serve on the Board of Governors of the Fed, later moving to President Clinton’s Council of Economic Advisers. Akerlof first commuted from Berkeley to Washington then took a leave of absence to join his wife in Washington. Both returned to Berkely in 1999. Akerlof was awarded the Nobel Prize in Economics in 2001. Yellen was named president of the Federal Reserve Bank of San Francisco in 2004. She was nominated to be Vice Chairman of the Fed in 2010.

For a number of Fed watchers, a Chairman Janet Yellen will not be all that different from a Chairman Ben Bernanke.

“Based on what she said before and generally how she has aligned with Bernanke, I don’t think we’re going to see that much of a change,” says Jay Brinkmann, chief economist at the Mortgage Bankers Association (MBA), who is retiring from his position this month.

“There may be a difference in rhetoric and there may be a difference in how she attempts to build a consensus on the board, but I don’t think in substance we’re going to see any sort of radical change from where Bernanke has been taking us,” he adds.

The view is widely held that Yellen will favor policies she believes will benefit economic growth. “So that means probably a continued ease for a while, although in our forecast we actually believe that the Fed will start slowing its purchase of securities in the March 2014 time frame and probably end the purchases outright in the early fall,” says Doug Duncan, chief economist at Fannie Mae, Washington, D.C.


Higher interest rates

Some observers expect Yellen to execute dovish policies even if it means higher inflation. “She is more willing to tolerate higher inflation in order to get more employment,” says Lawrence Yun, chief economist at the National Association of Realtors® (NAR), Chicago.

“Most people would consider 3 percent [inflation] the red line where the Federal Reserve does not want to cross. However, she may be willing to cross that red line of 3 percent inflation in order to get more employment,” he says.

An inflation rate of higher than 3 percent will lead many investors “to believe the Fed is willing to tolerate higher inflation,” notes Yun. “As a result, the long-term bond yields will be rising and the 30-year fixed-rate mortgage [FRM] rate will also be rising,” he says.

Yun does not expect any potential impact from Yellen’s perceived views on inflation to show up until 2015 or later. By then the continuation of easy monetary policy currently in place “could actually backfire from Yellen’s goal,” he says. That’s because “if the long-term yield rises, it will begin to pull back housing market activity.”

Most, however, expect mortgage rates to rise long before there are any signs of inflation.

“We are going to at some point start seeing considerable increases in mortgage rates,” says Mark Calabria, director of financial regulation studies at the Cato Institute, Washington, D.C.

“The pace of those increases and how sudden they are will really depend on how the Fed pulls off its exit strategy” from its massive program of purchasing Treasury and mortgage bonds, known as quantitative easing.


Quantitative easing

QE was first announced in late 2008. It has twice been extended and remains in effect. According to Fed statements, QE was undertaken to drive down longer-term rates and boost the housing sector by lowering the cost of borrowing and increasing the availability of credit.

Purchasing Treasuries also helped the housing sector because it lowered Treasury yields and mortgage rates are tied to 10-year Treasury yields. The combined effect was expected to help the Fed reduce unemployment and boost the general economy.

The Fed’s dual mandate, set forth by Congress in 1977, is to keep inflation low and promote maximum employment. With QE, the Fed tilted more toward lowering unemployment in a recovery that has been decidedly subpar in both economic growth and job creation.

QE is a sharp departure from the Fed’s traditional role in managing monetary policy that was focused on setting targets for the Federal Funds Rate and intervening in the market by selling or buying Treasuries to push short-term rates up or down toward the desired target rate. The Federal Funds Rate is the overnight interest rate charged by banks when they lend funds from their balances held at the Federal Reserve to other banks.

With QE, the Fed has sought to push down the level of longer-term rates and, thus, stimulate economic activity tied to longer-term borrowing costs.

The assignment--some say mission impossible--for Yellen and the Fed is to navigate the way out of QE. First, the unwind has to be done soon enough to minimize the potential the accumulated effect of easing will stoke of the flames of inflation, push up interest rates, create asset bubbles and push too much investment into riskier assets.

Yet, it cannot be done so soon that it sharply diminishes or ends the economic recovery.

No one is certain how Yellen will go about unwinding bond purchases and, after that, the disposition of the huge bond portfolio at the Fed.

“You never know exactly how anyone will act in the position until they are there because it’s a little different being chairman than being a member,” says Fannie Mae’s Duncan. “When you’re the chairman, you have to organize the whole group--and that may be slightly different than the way you think about things when you are simply a member.”

The Fed’s efforts at providing a stimulus to the economy- -keeping short-term interest rates close to 0 percent and purchasing trillions of dollars in bonds to lower long-term interest rates--is unprecedented in the central bank’s history.

So far, prices as measured by the Consumer Price Index (CPI) have risen only modestly. Prices actually fell 0.4 percent in 2009, rose 1.6 percent in 2010, rose 3.2 percent in 2011, rose 2.1 percent in 2012 and only 1.0 percent in the twelve months ending in October 2013

Unemployment has remained high while the share of working-age Americans participating in the labor force has declined. Unemployment, which stood at 6.1 percent in September 2008 when the financial crisis broke, rose to 10 percent in October 2009 and stood at 7.0 percent in November 2013.

The labor force participation rate, which stood at 66 percent in September 2008, has steadily fallen to 63.0 percent in November 2013, as the unemployed gave up looking for work.

QE is widely credited for boosting asset values in the U.S. stock market and driving up the value of equities in the emerging and frontier markets around the world, until Bernanke in May 2012 first indicated the Fed might be ready to start reducing its purchase of bonds--a process quickly dubbed “the taper” by market investors.

Expectations the Fed would start tapering in September 2013 were dashed when it did not do so, and since then interest rates have fallen back.


Higher inflation?

The marvel for some economists is, however, that so much monetary stimulus coupled with runaway federal deficit spending has not created a raging fire of inflation devouring the economy.

“If Milton Friedman were alive, he would be shooting himself in the head” over the Fed’s inflation-inducing policies, according to Laurence Kotlikoff, professor of economics at Boston University and a visiting professor of economics at the Massachusetts Institute of Technology (MIT), Cambridge, Massachusetts.

With very low interest rates for more than five years and the largest central bank intervention in history, some economist believe higher inflation may be inevitable.

“The reality is that the velocity of money is way down and the money multiplier is way down. If we went back to historic norms [for the velocity of money and the money multiplier], we could see the price level increase by a factor of 3.5 just based on what’s happened already” in terms of monetary easing, Kotlikoff warns.

“The backdrop of all this that the country is broke, fiscally speaking,” he says. “The fiscal position of the country is desperate. The Fed right now is printing 29 cents of every dollar the federal government spends,” Kotlikoff explains. “They’ve done things that could lead to hyperinflation, and they are still doing things.”

The bill for Bernanke’s policies may come due for the Yellen Fed, according to Kotlikoff, who thinks Yellen is “a terrific economist” and “the best person for the job.” He expects that she will excel at setting expectations for Fed policy and be able to calm the markets at a time of volatility. “She has a difficult job and lot of risks associated with it,” he says.

While Kotlikoff acknowledges that you can argue that what Bernanke did after the financial crisis to save the financial system “makes sense,” he contends the policies since then have been misguided.

The ongoing QE program “hasn’t worked in terms of turning the economy around. It creates a lot of uncertainty about the course of interest rates,” Kotlikoff says. It might not have been such a problem to devise an exit strategy if the United States had not pursued such reckless fiscal policies over the last six years, he says.

“The fundamental problem I see is on the fiscal side,” Kotlikoff says. “When the worldwide public ultimately understands how much money is being printed, then things might slip on a dime and you’d be looking at different interest rates and prices, and you’d be off to Zimbabwe,” he says, in a reference to the severe hyperinflation that has wracked that African nation’s economy.

However, the domestic economy has yet to see any serious increase in inflation, a point defenders of the Fed’s policy are quick to make. Yet, inflationary pressures can build up without being expressed and appear suddenly and strongly, according to Kotlikoff.

“If inflation takes off, what are they going to do? Are they going to sell bonds to try to raise interest rates? You’ve got to ask yourself in history when have countries printed this much money?”

The way forward for monetary policy is unclear. And the impact of implementing any of the policy alternatives being considered may be even less clear.

“Going from printing money to sucking it out will put a lot more pressure on Congress they will not be able to handle” as rising interest rates sharply increase the cost of the nation’s debt burden, says Kotlikoff. “It could get out of control,” he says, adding he is not sure if there has ever been a time in history when a country has printed as much money as the United States has in recent years without creating hyperinflation.


The QE exit strategy

Unwinding QE will be challenging because the size of the accumulated bond portfolio has grown so large. As of mid-November 2013, the accumulated bond purchases under QE had pushed the balance sheet of holdings to $3.631 trillion. That includes $2.137 trillion in U.S. Treasury securities and $1.435 trillion in agency MBS plus $59 billion in agency debt securities. By comparison, the Fed had only $800 billion in assets prior to the crisis.

QE1, which began in December 2008 and ran through March 2010, added $1.7 trillion in purchases of Treasuries and agency MBS. QE2, lasting from November of 2010 to June of 2011, added $600 billion; and QE3, from December 2012 to the present, has been adding $85 billion a month in Treasuries and agency MBS.

Add into the mix the fact QE has delivered increasingly less effect on interest rates through each subsequent round.

In an August 2013 presentation at the Jackson Hole, Wyoming, conference sponsored by the Kansas City Fed, Arvind Krishnamurthy, professor of finance at the Kellogg School of Management at Northwestern University in Evanston, Illinois, said his analysis had found that QE3 had significantly less effect on mortgage interest rates than the earlier two rounds.

QE3 had led to only a 16-basis-point decline in 30-year interest rates, according to Krishnamurthy, compared with 23 basis points for QE2 and 107 basis points for QE1.

Kansas City Fed President Esther George, a voting member of the Federal Open Market Committee (FOMC), has expressed doubts about the wisdom of continuing QE because of its declining effect on interest rates (and thus the economy). George also worries about the growing size of the Fed’s balance sheet and the fact that as it increases, it will intensify the challenge of unwinding it.

“My preferred course of action is to begin the process of reducing asset purchases,” George told a gathering of the Shadow Open Market Committee (SOMC) meeting at the Cornell Club in New York on Sept. 20. She dissented on the FOMC’s September vote to postpone the start of tapering.

Another challenge lies in that fact that if QE continues with the same level of purchases of Treasuries and MBS, it will increasingly take a larger and large role in the mortgage market, as mortgage originations decline in the face of rising interest rates.

“The mortgage market is obviously tapering,” says Brinkmann. “If the Fed is still locked into a $45 billion target all through 2014, based on our expectations, the Fed will be buying close to 80 percent of GSE [government-sponsored enterprise] securitizations and 45 percent of all mortgages originated,” he adds.

“Do we really want a situation where the Fed is holding that much of the market?,” he asks. “At some point there would not be enough mortgages to buy unless they buy them out of people’s portfolios.”


The Fed’s carry trade

Andrew Huszar, the portfolio manager who ran the Fed’s purchase of mortgage-backed securities, now a senior fellow at Rutgers Business School, has gone public with his view that the program has not achieved its objective while at the same time increasing risks tied to the ultimate unwinding of the policy.

Huszar, who managed the then-$1.25 trillion program to buy mortgage bonds in 2009 and 2010 at the New York Fed, stated his views in a Nov. 12 op-ed in The Wall Street Journal titled “Confessions of a Quantitative Easer.”

The risks of unwinding the portfolio exist for both scenarios: holding the bonds to maturity, as Bernanke has suggested, or selling them off gradually into the market, according to Huszar.

Today the agency MBS portfolio is at $1.435 trillion, which is even higher than when Huszar managed it.

“Historically we’ve seen mortgage-backed securities have had somewhere between a seven- to 10-year duration, and that could extend substantially because these are mostly 30-year mortgage-backed securities,” says Huszar in a separate interview. “If rates start rising, you have this extension [of duration] risk because people are not paying down their mortgages as quickly as possible and people are not moving,” he explains.

The huge mortgage bond portfolio represents “effectively a carry trade that the Fed has on its books right now,” Huszar says. Like all carry trades, it holds the potential that the funding costs could rise above the yields paid on the bonds, causing the trade to unravel. “It’s a bit of a ticking time bomb for the Fed,” says Huszar.

The Fed technically funds its purchase of bonds by printing electronic dollars as reserves and uses those dollars to buy bonds. “But there is an effective funding cost for the Fed--namely, the banks who get the reserves have the option of banking them at the Fed and getting interest,” Huszar says. “Right now, interest on excess reserves (IOER) is 0.25 percent. But if interest rates spike when the Fed is still carrying a significant bond portfolio, the risk is that the Fed will have to pay more interest on IOER than the yield it is getting from its bonds--hence the risk of negative carry trade,” he explains.

If the Fed chooses not to hold its bonds to maturity, it faces a different kind of risk. “From Yellen’s perspective, there’s a huge asset-management question mark here going forward,” says Huszar.

The execution of the mortgage bond-buying program at the New York Fed in 2009 and 2010 was difficult to manage to avoid creating unwanted market disruptions because of the enormous size of the purchases, according Huszar. Selling them back into the market will be even more difficult.

“How the Fed would actually go about liquidating a mortgage-backed securities portfolio is a huge untested proposition,” he says. What would be the knock-on effects, not only to the functioning of the TBA [to be announced] market and the overall mortgage market, but also to the entire U.S. housing sector? I think these are potentially massive challenges for the Fed.”

The impact of a Fed announcement that tapering will begin may not have as big an impact on interest rates as feared, according to Mark Fleming, chief economist at CoreLogic, Irvine, California.

“I think it is one of those scenarios were the markets have built in that taper already,” he says. That is, the jump in mortgage rates that occurred from May to September largely priced in the full effect of the taper. “It will be interesting to see if there is any significant increase in rates when they actually announce the taper,” says Fleming.

Michael Youngblood, principal and co-founder of Five Bridges Advisors LLC, Bethesda, Maryland, sees the potential that mortgage rates could fall significantly from their levels above 4.3 percent. Youngblood attributes the sharp run-up in interest rates in 2013 to “the announcement effect, whereby the market prematurely expected the Fed to start assets sales and move from accommodation to a restrictive monetary policy.”

The “announcement” came as an unscripted comment Bernanke made last May indicating that the Fed could reduce its asset purchases in the near term. After seeing interest rates spike, “the Fed has gone to great lengths to go back on message, and we’ve seen a modest reduction in rates as a result,” Youngblood adds.

The level of interest-rate increase from the announcement effect could be largely reversed, according to Youngblood. “If the Yellen Fed continues this policy of consistently stating its goals, we could work off [the 2013  increase and] that could bring us back to 3 percent mortgage rate, revive refinance activity and lead to a modest stimulus of new- and existing-home sale activity,” Youngblood says. “And if the housing sector can recover and resume its historic contribution to the GDP [gross domestic product], the entire economy is lifted as well.”


Housing recovery

For the housing sector, the decisions of Yellen’s Fed in devising an exit strategy from QE will likely be decisive in determining whether and when the housing recovery now underway eventually reaches something approaching historic norms as measured by new-home construction at 1.6 million to 1.7 million, according to Fannie Mae’s Duncan.

That’s the level of residential construction that demographics suggest are required to keep pace with housing demand from an expanding number of households.

Housing starts, which were running at an annual rate of 891,000 in August 2013, rose to an annual pace of 974,000 in September and then rose to an annual pace of 1,034,000 in October, according to the U.S. Census Bureau and the Department of Housing and Urban Development

The Fed is paying attention to housing activity as an indicator to watch and then adjust its QE exit strategy. “Once they start this, they may learn something that could change the pattern, too,” Duncan says. “If they see some widening of spreads they don’t like, based on the pace of the slowdown in the securities purchases of both types, then they can alter that based on what they learn.”

Market observers generally expect the Fed will try to manage the exit from QE so that the impact on interest rates occurs in a measured way. “Whether they can accomplish that or is not will be part of the challenge,” says Duncan.

Mortgage rates remain attractive from a historic standpoint despite a run-up that began in May 2013 on taper talk. The weekly Freddie Mac average for the 30-year mortgage rose from 3.35 percent on May 2 to 4.57 percent on Sept. 12--more than 100 basis points. The average rate fell back a bit after that, then resumed rising, reaching 4.48 percent by Dec. 28.

While the average 30-year fixed mortgage rate since World War II is 6.5 percent, if you take out the inflationary period of the late 1970s, it has averaged closer to 5.5 percent, according to Duncan.

Most economists agree that the long-term interest rate for 10-year U.S. Treasuries is 3 percent to 3.5 percent, Duncan explains, and because mortgage rates can be 150 to 200 basis points above that, it would put them at 5 percent to 5.5 percent. “I think most people expect rates to rise and that’s probably a level people should not find unexpected,” says Duncan. “Of course, if we see inflation increase, we will see numbers above that.”


Labor market signals

In the end, the markets expect the Fed is going to wait until labor markets have sufficiently improved before the tapering of bond purchases begins. The Fed had originally indicated that it could start tightening (raising short-term interest rates) when unemployment falls to 6.5 percent. Last May, Bernanke indicated that tapering could begin when unemployment reaches 7 percent.

However, the Yellen Fed might also decide when to taper based on other labor market data.

At least one observer--CoreLogic’s Fleming--expects the Fed to closely following the Bureau of Labor Statistics’ (BLS’) Job Openings and Labor Turnover Survey (JOLTS).  “The number of people quitting or being involuntarily laid off can tell you where the job market is going,” he says. If more people quit their jobs, as opposed to involuntary layoffs, then it is a sign of an improving labor market.

The Fed trumpets the fact its decisions on tapering and monetary policy in general will be data-driven. It is not clear which data will be decisive for the Yellen Fed when it comes to the timing of the taper.

Whenever the tapering proceeds, it promises to be a journey into uncharted waters. It could be smooth sailing. It could be tumultuous. It will certainly be a central focus of the mortgage industry and the housing sector, and a key focus for the American public as well. But Chairman Yellen will be there to help us see it through. MB


Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Copyright © 2014 by Mortgage Banking Magazine. Reprinted With Permission.



Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

Visit Mind over Market:

Mind Over Market

Click Here>>