Fed Focus Turns from Finding Capital for Lenders to Battling Inflation

Jul

2008

Jim Haughey

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Financial markets were relatively calm over the past month. The policy set federal funds and prime bank rates moved down about 20 basis points while market interest rates moved up about 20 basis points bringing the two sets of rates into a more normal relationship which typically suggests no significant rate changes are expected in the next few months. As a result mortgage interest rates were approximately steady over the last month.

While a few laggard lenders are still looking to replace the capital they lost in their subprime mortgage investments, lenders are generally past their capital adequacy problems. The financial crisis has moved downstream to builders, developers and homeowners who need to add or refinance construction or mortgage debt. Credit approval standards continue to tighten as borrowers continue to present weaker income and balance sheets in a recessionary economy. The impact of lenders’ caution will be to force some weak borrowers into panic sales which adds to the competition for new construction. Speculative building will also be restrained well into next year.

That said, credit is and will remain available at below average rates for borrowers with good credit records.

Nonetheless, commercial and jumbo mortgage rates will continue to have larger than normal spreads over prime conforming residential rates. That is because these investments are speculative; the borrower-owner has to find a tenant in an economy with subpar growth and no certainty yet when economic growth will return to the normal (3%) range. The current spreads should gradually diminish through the end of next year.

The Federal Reserve Board appears to done with rate cuts. Interest rate futures prices suggest that the offsetting period of rate increases will begin early in 2009.

Inflation expectations have been inching higher and are now about 0.4% above actual recent inflation. The Federal Reserve Board will let this gap persist for a while longer because they believe there is at least a small reversal in energy prices soon ahead which will bring expectations back into line with actual inflation. But if this does not happen by the end of the summer, the resumption of rate increases may come yet this year. This would worsen already weak construction demand. But, in this scenario, it is necessary to prevent the “buy now before it gets more expensive” behavior that set off the long period of rising inflation in the 1970s.

U.S. Construction Finance Environment — July 2008

	Financial Market Benchmark Rates
	Previous				Annual Average
	Month				Actual		Forecast
	(Jun 08)	Latest			2006	2007	2008	2009
		Week Ending
Federal Funds Rate (overnight)	1.99	Jul 9 08	1.95		4.96	5.02	2.35	2.73
1-Year Treasury Bill (T-Bill) Rate	2.51	Jul 11 08	2.25		4.93	4.52	2.17	2.66
10-Year Treasury Bill (T-Bill) Rate	4.15	Jul 11 08	3.90		4.79	4.63	3.93	4.48
Prime Bank Rate¹	5.00	Jul 9 08	5.00		7.96	8.05	5.32	5.53
¹ Base for home equity, contractor and business investment loans

	Mortgage Loan Rates
	Previous				Annual Average
	Month				Actual		Forecast
	(Jun 08)	Latest			2006	2007	2008	2009
		Week Ending
1-Year Adjustable Rate Mortgage	5.19	Jul 17 08	5.10		5.53	5.56	5.13	5.11
5/1 Adjustable Rate Mortgage	5.89	Jul 17 08	5.8
15-Year Fixed Rate Mortgage	6.02	Jul 17 08	5.78
30-Year Fixed Rate Mortgage	6.42	Jul 17 08	6.26		6.41	6.34	6.05	6.22

	Previous					Highlights All rates declined in response to weak loan demand and aggressive monetary easing but long rates will rise with rising inflation expectations and short rates will rise with tighter monetary policy.
	Month		Latest

Core Inflation Rate²	2.1% (Apr 08)		May 08	2.1%
Inflation Expectations³	2.55% (Jun 08)		Jul 8 08	2.45%
²Based on personal consumption expenditures (less food and energy), year over year. ³Based on rates for 10-Year inflation-protected Treasury securities.