The American economy, like most world economies today, is run on a system of fiat money, or money that is assigned its value by government decree. Since this money has no intrinsic value of its own, its value and supply must be carefully managed and regulated, not just within the nation’s borders but also in accordance with the economies of all other nations. In light of this need for careful stewardship of the economy, the United States maintains a central bank, called the Federal Reserve (or, more commonly, the Fed).

The Fed as it exists today is actually the United States’ fourth attempt at founding a central bank. In the midst of the Revolutionary War, America’s Continental Congress ratified the Articles of Confederation, which, among other edicts, gave Congress the power to issue bills of credit. A private national bank, modeled after the Bank of England, was established shortly thereafter, but was denied the opportunity to become a central national bank due to unease about foreign influence and other political concerns. The official First Bank of the United States was created in 1791, and lasted 20 years before being denied a renewal of charter by President James Madison. The Second Bank of the United States opened in 1816, and it too only lasted 20 years before President Andrew Jackson shut it down. Political opposition to the very idea of a central bank had been a chief culprit of these failures, and it would be almost a century before the United States would try again.

In 1907, a profound financial panic occurred, a direct result of a failed attempt by stock traders to corner the market on shares of the United Copper Company. The failure created a series of bank runs on those institutions that had backed the bid. As is often the case with bank runs, the atmosphere of worry spread nationwide, causing other banks to suffer runs and even leading to the collapse of, at the time, the third-largest financial trust in New York City, the Knickerbocker Trust Company. With no central bank in existence to attempt stabilization of the economy with an infusion of currency, the only reason that the crisis did not fling the country into irreparable economic turmoil was the work of private business tycoons such as J.P. Morgan, who banded together and contributed much of their own capital to bolster the banks. It was this barely dodged catastrophe that led to a series of financial reforms over the next few years, culminating in 1913 when Congress and President Woodrow Wilson passed the Federal Reserve Act.

In structure, the Federal Reserve is unique among the world’s central banks. Although it is designed to function as an entity “independent” of the federal government, thereby limiting its exposure to political influence, the Fed also employs a mixture of private and public sections in its operation—most similar banks in the world operate under either entirely private or entirely public ownership. It is also the only such bank to not make its own currency (which is instead printed by the United States Treasury). The Fed is managed by a Board of Governors, all of whom are presidential appointees, and is also comprised of the Federal Open Market Committee (FOMC) and representatives from twelve other Federal Reserve Banks located throughout the country.

The Fed has been reformed a number of times since 1913, especially so after the recovery from the Great Depression. Currently, its chief mandate is to provide the means to deal with bank panics, but it also sets interest rates, operates as a lender of last resort in case the banking system is in need of capital, and generally regulates the entire money supply by balancing the factors of employment rates and inflation. The importance of these functions to the American economy cannot be overstated. Any competent financial player in any market knows that a key component of success or ruin is an ability to observe, analyze, and possibly predict the actions of The Fed…and any competent Board of Governors is aware that The Fed is being closely watched.

Market Comment
Mortgage bond prices fell last week applying slight upward pressure on home loan rates. The market remained very volatile within a narrow range. Oil remained above $80 a barrel, reigniting inflation concerns. The retail sales report released Friday was better than expected, indicating the US economy may be getting stronger.

Rates rose about 1/8 of a discount point for the week.

The Fed meeting Tuesday afternoon will be the most important event this week. The inflation data from both the consumer and producer sides will also take center stage. If inflation remains in check, mortgage bonds could benefit.

Producer Price Index
The producer price index (PPI) is a measure of prices at the producer level and is important because it is the first inflation report to be released each month. Investors are typically able to gain an initial indication of inflationary pressures from the release. If producer prices increase, there is a tendency for producers to pass the increases on to consumers in the form of higher priced goods. It is important to note that the PPI is only a measure of goods, while the consumer price index (CPI) is a measure of goods and services.

It is possible for the price of goods to remain stable, while the price of services increases. In this scenario, PPI would do little to warn of a change in inflationary pressures, while the CPI report would provide an indication of the inflationary effects of the service component. This distinction between the two reports shows why most analysts view the CPI as a more accurate indicator of inflation. Nevertheless, market participants still gain valuable insight into potential fluctuation in the financial markets from the PPI release.

Be cautious heading into the inflation data and Fed meeting this week.

Market Comment
Mortgage bond prices rebounded last week, pushing mortgage interest rates lower. The majority of the data came in bond friendly. Tuesday’s weaker than expected consumer confidence data helped mortgage interest rates improve. The Treasury auctions showed decent foreign demand. The gross domestic product price deflator component showed a smaller price increase than expected. Consumer spending component also came in weaker than expected. Existing home sales fell a surprising 7.1%, considerably weaker than the expected 1% increase.

Rates fell about 3/4 of a discount point for the week.

The employment report Friday morning will take center stage this week. Until then, look for the PCE inflation data to set the tone for the beginning of the week and the ADP employment report to set the tone for the mid portion of the week.

Fundamental Week
The abundance of fundamental data this week provides a good opportunity for mortgages to improve. If the data shows weakness in the economy with little or no inflationary pressures then it is possible for mortgage bonds to rally resulting in mortgage interest rate decreases. However, if the data shows that the economy is rebounding or any significant signs of inflation, mortgage bonds may fall, pushing mortgage interest rates higher.

Mortgage interest rates remain favorable. Now is a great time to avoid the uncertainty surrounding continued market fluctuation.

Market Comment
Mortgage bond prices rose last week, pushing mortgage interest rates lower. The bond market was buoyed by the announcement that US Treasury increased Fannie Mae and Freddie Mac credit lines to a total of $400 billion. This was a signal to investors that these entities are “too big to fail”, as viewed by the Treasury. We saw some weakness Thursday afternoon as retailers reported stronger than expected holiday sales. The employment report Friday was generally bond friendly.

For the week, interest rates fell by about 1/4 of a discount point.

The inflation data Friday will be the most important economic data this week. Signs of stronger than expected inflation would not be positive for mortgage interest rates. The Treasury auctions will also dominate trading. Stronger than normal foreign demand could bode well for the overall level of interest rates.

Employment Results
The December employment report came in relatively bond friendly. Unemployment came in at 10% as expected. However the payrolls component showed job losses of 85,000 compared to the 35,000 losses expected by analysts. The mortgage bond market had a generally positive reaction to the report but improvements in rates were tempered by concerns for some of the revised data from prior months. Revisions to the November figures showed a 4000-job increase as opposed to the original 11,000-job decrease.

Market Comment
Mortgage bond prices rose last week pushing mortgage interest rates lower. Rates initially spiked higher, following higher than expected producer price index figures. Fortunately, the consumer price index showed tame inflation on the consumer level and mortgage bonds were able to recover. The Fed kept rates unchanged, indicated they would try to keep rates low for some time, but also warned that long term security purchases would cease at the end of Q1 2010.

For the week, interest rates fell by about 3/8 of a discount point.

The inflation data will be the most important release this week. The recent inflation reports were mixed. The PCE price index will be carefully watched for any signs of inflationary pressures. The bond market will close early Thursday in advance of the Christmas holiday Friday. The shortened trading week may result in some market fluctuation.

Mixed Message
Last week, the Federal Reserve left interest rates unchanged. The remarks were mixed and caused some mortgage market uncertainty. The Fed statement indicated, “subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.”

The Fed’s challenge will be stepping out of the mortgage market without causing mortgage interest rates to spike uncontrollably higher. The housing sector is a vital component of the economy. The last thing the Fed needs is for mortgage interest rates to escalate causing the housing sector to suffer. While the most recent data shows positive housing trends across most of the nation, analysts attribute the positive movements to artificially low mortgage interest rates tied to the Fed buying of mortgage bonds. As always, it’s best to jump on the boat while you can and take advantage of historically low rates.