Federal reserve at sunset

President Donald Trump recently nominated Jerome Powell to be the next chairman of the Federal Reserve. His nomination was then approved by the Senate Banking Committee, and if confirmed by the full chamber, he would become the 16th chairperson of the Fed when current chair Janet Yellen’s term expires in February 2018.

The Federal Reserve makes a lot of important decisions regarding both monetary policy and regulation of the banking system, so any changes on the board are worth knowing about. The chair may also use their influence to determine which areas the Fed should be watching or working to move in a different direction.

We thought we would talk to Quicken Loans Vice President of Mortgage Policy Adam Krahn to get his thoughts on Powell’s attitudes toward economic policy and what it might mean for the mortgage market if you’re looking to buy or refinance a home.

What Are His Policy Attitudes?

Governor Powell has been confirmed for his current position twice by the Senate, so analysts do have a fairly good idea of where he stands on many issues at this point.

Krahn said he expects many of the current policies to continue, possibly at a slightly faster pace.

“We know from his voting record and public commentary that generally speaking he’s a centrist, but perhaps he has a slightly more hawkish disposition than the current chair, Janet Yellen,” Krahn said. “Modestly raising interest rates and normalizing the balance sheet over a measured period of time while the economy improves will likely be his strategy to lead the Fed – this should sound very familiar because it is how the Fed has been led for quite a while.”

There are some complex issues being talked about there. Let’s briefly go over some terminology to make this easier to understand.

Understanding the Fed’s Monetary Policy Tools

We’ll get into this a little bit more below, but for right now, know that one of the Fed’s major tools for controlling inflation is to set short-term interest rates. When rates go down, inflation is more likely to go up because there’s more money in the market. But it’s cheaper to get loans for things like houses or cars. If rates go up, prices stay under control because there’s less money in the market, but it becomes more expensive to borrow money.

What’s balance sheet normalization? Let’s take that in two parts, starting with an explanation of the balance sheet.

The balance sheet is essentially the Fed’s budget. It’s a little weird to think about the central bank having a budget because the Fed is in charge of printing money. But if you print too much, inflation runs rampant, and prices skyrocket. So they do have to be careful.

What about normalization? Back during the housing crisis, the Federal Reserve took a series of actions that were known as quantitative easing, a program that took place in a few different phases over a number of years. The goal is to jumpstart a struggling economy by keeping interest rates low and also taking the more unusual step of buying a bunch of assets on the open market. Over time, the Fed became the biggest buyer of mortgage-backed securities (MBS), holding over $1.7 trillion.

Since mortgage rates correlate with bond yields (when investors are in the mood to buy bonds, the rate of return doesn’t have to be quite as high translating to lower mortgage rates and vice versa), the impact of having a buyer with such an appetite for mortgage bonds helped keep rates low.

Normalization refers to the Fed’s plan to sell these assets back into the market in order to make sure they have room in the balance sheet to give them options in the event of another financial crisis.

The Unknowns

Krahn said the choice of Powell to lead the Fed gives Trump the opportunity to put his stamp on the board without spooking the markets by bringing someone in that will institute a major policy change.

However, it goes beyond Powell. With Yellen stepping away from the board at the end of her term as chair, President Trump will have four vacancies to fill on the seven-member board. This isn’t the most urgent thing, because the board has been operating without seven governors for a while, but it does mean there may be a shift in viewpoints on the board as new governors are nominated and take their posts. This adds a certain number of unknowns.

“President Trump is often seen as putting policy adversaries at odds and letting them fight it out,” Krahn said. “This could still create discord within the Fed, depending how the Vice Chair and other seats are filled in the months ahead.”

As an example, if President Trump were to nominate economist John B. Taylor to the Fed Board of Governors, this would bring a voice to the board advocating for rules-based monetary policy. As opposed to the current approach to making moves at its discretion being adopted by the Fed, a believer in rules-based monetary policy believes that the central bank should take actions prescribed in advance when certain economic conditions are present.

In addition to a turnover in people, it’s not possible to know how the board members might react to a crisis like a recession or a major bank failure until it actually happens.

Effects on Mortgages

One area where it remains to be seen how things will play out is in the mortgage market. Krahn said Powell supports the continuation of the process begun under Yellen in terms of selling off MBS to bring the Fed’s balance sheet back in line.

Part of the question on the minds of home buyers may be which will win out in the end: inflation trends or the pushing of the Fed’s MBS back into the mortgage market. Let’s explore this briefly.

Starting about two years ago, the Fed slowly began raising short-term interest rates from the near-zero levels that had been seen since the housing crisis. The idea is if you keep rates too low for too long, the probability for high levels of inflation increases. However, inflation has remained fairly stagnant to this point. Because of this, mortgage rates have remained fairly low recently.

The other issue that could cause mortgage rates to rise is the Federal Reserve selling its portfolio of MBS. For starters, the Fed has a huge number of these bonds. That means other buyers in the market will have to absorb what they’re selling in a major way in order for mortgage rates to stay around their current levels.

Krahn brought up a second problem the Federal Reserve may have. This has to do with the relative liquidity of Fannie Mae and Freddie Mac bonds. Fannie Mae bonds make up about 60% of the conventional mortgage market and Freddie Mac accounts for the other 40%. However, investors don’t tend to trade the bonds at the same rate.

“Over the years, the market sort of ‘decided’ to trade the Fannie Mae MBS much more often, and buy-and-hold Freddie Mac MBS much more often,” Krahn said. “It’s sort of like the market decided Fannie was their checking account while Freddie was their savings account. As a result, for every $100 traded, about $90 is Fannie MBS and $10 is Freddie.”

The key thing to remember here is that the market typically trades $10 worth of Freddie Mac bonds for every $100 of MBS trading. If the Fed puts out their sales based on the amount of loans closed vs. the amount the market actually has the appetite for, someone will have to step in and buy a ton of that Freddie Mac bond volume. If that doesn’t happen, it could cause fluctuations in mortgage rates.

Whether mortgage rates are impacted by inflation and short-term interest rate movements or the way the Fed chooses to sell its remaining MBS will be interesting to keep an eye on from a monetary policy perspective.

Another potential wildcard specific to Powell is that he has mentioned the need for housing finance reform. This could have an impact on the mortgage industry, pushing rates up or down depending on the actions that are undertaken.

There are a lot of unknowns, but one thing we know for sure is that rates are pretty low right now. Whether you’re in the market to buy or refinance, it’s a really good time to get that application started. If you’d rather get started over the phone, you can give us a call at (800) 785-4788.

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