Federal Reserve Chairman Ben Bernanke says the Fed will hold the line on short-term interest rates for now, but Bernanke also detailed the steps the Fed will eventually have to take to head off inflation, which are expected to raise the cost of borrowing.

In prepared testimony to lawmakers, Bernanke said the Fed intends to hold a key short-term interest rate, the federal funds overnight rate, at its current record low for an "extended period" (the Fed chairman was scheduled to testify before the House Financial Services today, but the hearing was cancelled due to weather).

Federal Reserve Chairman Ben Bernanke says the Fed will hold the line on short-term interest rates for now, but Bernanke also detailed the steps the Fed will eventually have to take to head off inflation, which are expected to raise the cost of borrowing.

In prepared testimony to lawmakers, Bernanke said the Fed intends to hold a key short-term interest rate, the federal funds overnight rate, at its current record low for an "extended period" (the Fed chairman was scheduled to testify before the House Financial Services today, but the hearing was cancelled due to weather).

But when the time comes to tighten monetary policy to "prevent the development inflationary pressures," Bernanke said the Fed intends to raise the rate it pays on banks’ excess reserves. That would push short-term interest rates up, and put upward pressure on long-term rates as well.

"By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks," Bernanke said. "Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally."

Mortgage rates are expected to rise after the Federal Reserve wraps up ongoing purchases of $1.25 trillion in mortgage-backed securities (MBS) at the end of March.

In a Jan. 12 forecast, the Mortgage Bankers Association projected rates on 30-year fixed-rate mortgages will rise from an average of 4.9 percent during the final quarter of 2009 to 6.1 percent in the final quarter of 2010, 6.3 percent in the last quarter of 2011, and hit 6.6 percent during the last three months of 2012.

William Dudley, president of the Federal Reserve Bank of New York, has said that while he expects the Fed to wind down its MBS purchases at the end of March as planned, the program could always be restarted if the consequences of shutting it down are more severe than expected (see story).

Bernanke said that once the Fed decides it’s time to tighten monetary policy, it could also choose to sell securities including the MBS it been purchasing to help keep mortgage rates low. …CONTINUED

That could put upward pressure on mortgage rates. If the Fed tried to unload its MBS purchases too quickly, investors might not be eager to snatch them up, pushing their prices down. When bond and MBS prices fall, yields move in the opposite direction.

Bernanke promised that any sales of MBS and other investments the Fed has made to prop up the economy "would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions."

For now, he said, the Fed is simply allowing the MBS it has purchased to run off as they mature or are prepaid, and is also rolling over maturing Treasury securities.

Shrinking demand for purchase loans outweighed a slight bump in applications for refinancings, pushing applications for mortgages down a seasonally adjusted 1.2 percent for the week ending Feb. 5, the Mortgage Bankers Association said in releasing results of its Weekly Mortgage Applications Survey.

Although mortgage rates were mostly down, demand for purchase loans fell by a seasonally adjusted 7 percent from the previous week. Applications for refinancings were up 1.4 percent, the MBA said.

Applications for refinancings accounted for 69.7 percent of all mortgage applications, up from 69.2 percent the week before. Requests for adjustable-rate mortgage (ARM) loans accounted for 4.5 percent of applications.

The average contract interest rate for 30-year fixed-rate mortgages decreased to 4.94 percent from 5.01 percent, with points increasing to 1.06 from 1.04 (including the origination fee) for 80 percent loan-to-value (LTV) ratio loans.

The average contract interest rate for 15-year fixed-rate mortgages remained unchanged at 4.33 percent, with points decreasing to 0.95 from 1.17 (including the origination fee) for 80 percent LTV loans.

The average contract interest rate for one-year ARMs decreased to 6.68 percent from 6.7 percent, with points increasing to 0.35 from 0.34 (including the origination fee) for 80 percent LTV loans.

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