Deadstick landing

Does Fed chairman Ben Bernanke see himself as the pilot of the U.S. economy, attempting to make a deadstick landing aboard the U.S.S. Housing Market?

Before the invention of the ejection seat, pilots taking off and landing from aircraft carriers were pretty much doomed if they lost engine power below the altitude where their parachute could open in time to save them if they were forced to bail out. Nowadays, they can ride a flameout right down to the deck, if need be, and eject at the last minute -- their rocket-powered seats will propel them high enough for a safe descent by parachute.

After taking a beating at the tail end of 2007, stocks have really flamed out in the New Year. Thanks in part to gloomy numbers on unemployment and manufacturing, the Dow Jones Industrial Average plummeted 256 points today and is down 750 points since the day after Christmas, or about 5.5 percent.

The credit crunch that erupted last summer, leaving many subprime and alt-A mortgage lenders unable to finance new loans, shows little sign of abating, either. So the Fed announced today that it would make up to $60 billion in short term loans available to banks this month, up from $40 billion in December (see Inman News story).

All of this seemingly bad news could help housing markets recover, by pushing mortgage rates down. As investors pull money out of stocks and put it into safe bets like Treasurys and other bonds, that brings interest rates down. Even mortgage-backed securities -- at least those built around prime mortgages with backing from Fannie Mae and Freddie Mac -- are considered a safe haven by many investors.

So mortgage rates could be headed below the 5.25 percent bottom seen from 2002 to 2004, mortgage broker and syndicated columnist Lou Barnes writes today -- unless the Fed sees the need to attempt a dramatic rescue of the economy.   

While many Wall Street investors are hoping the Fed will continue to slash short term interest rates to stimulate economic growth (it's lowered the federal funds overnight rate three times since September, to 4.25 percent), Barnes says that could send long-term rates in the other direction.

"The bond market won't like the inflationary consequences. The economy and especially housing need lower long-term rates; if the Fed appears to abandon discipline, long rates will rise no matter how far the Fed cuts," Barnes writes.

So while he can't say so publicly, Bernanke has to let the economy slide toward recession until inflation is under control, Barnes theorizes.

The Fed chair "must engage in brinkmanship to hold inflation below the 2 percent bound -- a priority on nobody's screen except bond investors," he says. That's not something that's easy to explain to the public, but "It's the only way to get long-term rates down, and to achieve a durable rescue."

Going back to the ejection seat analogy, Bernanke and the Fed's Open Market committee could hit the eject button now by making drastic cuts in short-term interest rates. But they'd rather let the economy continue to lose altitude in the hopes of saving their multibillion dollar aircraft from the drink.

The ejection seat analogy (which is mine, not Barnes') may be lacking in at least one respect: what, if anything, can still be saved if Bernanke hits the short-term interest rate ejection button too late? Bond investors?

Expectations of a big rate cut at the Federal Open Market Committee's next meeting Jan. 30 have soared, by the way, with futures market investors betting on a 50-basis point reduction in the federal funds rate to 3.75 percent (that's the red line in the chart below from the Cleveland Fed (click for full size)).

If Bernanke and company are NOT ready to hit eject at the end of the month, expect stocks to tank and long-term interest rates -- including mortgages -- to come down more.

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