The Federal Reserve is facing a difficult but necessary transition from activist investor to pulling back its involvement and allowing higher short-term rates when the economy can stand on its own.
Last week the Federal Reserve took a small step toward reducing its involvement by raising the discount rate by .25% (The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility). The Fed did recently indicate that the move might be coming, yet the timing of their announcement was surprising to many.
At the start of the credit crunch in mid 2007, nearly one-third of the U.S. lending mechanism was frozen. To increase their liquidity, banks had the option to access the Discount Window at the Federal Reserve (Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.) However, because costs for these funds were high AND repayment had to be done within 28 days, most lenders were unable to utilize this option. As a result, the Fed held an emergency meeting, lowered the Discount Rate and extended the repayment period to 90 days. These changes made the Discount Window option a viable solution for lenders and helped curtail the severity of the mortgage meltdown. Last week’s announcement reverses those emergency measures.
When making this change, the Fed noted that the continual improvement in financial market conditions gave them the foundation for this move. The Fed also said that they do not anticipate this raise to lead to tighter financial conditions for households or businesses nor does this move indicate any change in their outlook for the economy or for monetary policy.
However, as the Fed makes changes, the government backs out of Mortgage Backed Securities (MBS) purchases and slows down stimulus programs, we continue to assess economic growth and inflation concerns.
With that in mind, one of the most popular measures of inflation within the U.S. is the Consumer Price Index (CPI). The CPI measures the estimated average price of consumer goods and services purchased by households. This index rose by 0.2% for January, less than the 0.3% expected. With the publishing of the January results, the year-over-year CPI is at 2.6%, below expectations of 2.8%. The more closely watched Core CPI (which strips out food and energy costs), actually fell by 0.1%, below expectations of a 0.1% rise. The last time Core CPI showed a negative monthly reading was 28 years ago. This helped to drop the year-over-year Core CPI rate to 1.6%, a bit below expectations of a 1.8% rise.
These results show that, for the time being, inflation is a non issue. However, it will likely become a factor in the next year or two. And, the best hedge for inflation is to fix as many costs at today’s prices as you can. A home purchase today with a historically low mortgage rate allows buyers to fix the price of their home and the associated financing costs. We will continue to keep an eye on this index and other economic indicators.