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.

Last week, current Federal Reserve Board Chair Ben Bernanke was reconfirmed for another four years by the United States Senate in a 70-30 vote. Who is Ben Bernanke, and what exactly does the Fed chair do? PERL Mortgage Advisor and top 200 producer Barry Schwartz explains the role of the Fed and its current leadership.

Click the play button to listen!

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 fell last week pushing mortgage interest rates significantly higher. We saw selling pressure almost the entire week as housing and factory orders data was stronger than expected, the Fed Chairman mentioned rate hikes, and weekly jobless claims beat estimates. To top the already negative week, the employment report came in stronger than expected causing rates to spike even higher Friday morning.

Interest rates finished the week worse by about 1 and 1/2-discount points.

The continued Treasury auctions will gain a lot of attention this week. If foreign demand for the debt is weak, we could see rates head higher. The first portion of the week is light regarding economic releases, but the trade data Thursday and retail sales data Friday have the potential to result in mortgage interest rate fluctuation. Be alert throughout the entire week.

Are Rate Hikes Coming?
The biggest fear of bondholders is inflation. Real or perceived, inflation erodes the value of fixed income securities causing prices fall and rates to rise. And the housing sector of the economy would certainly not benefit from escalating mortgage interest rates. Unfortunately comments from Fed Chairman Bernanke have many traders concerned that rate hikes are on the way. Bernanke indicated the Fed would follow a “rolling exit process”, in which special programs run down and ultimately implement a tightening policy. He went on to mention raising rates and indicated the Fed will cut back and close emergency lending programs as the markets normalize. The reaction to these remarks was fast and furious as mortgage interest rates shot higher.

While it is almost inevitable that the Fed will eventually raise rates, no one knows when that will occur. However, many traders took Bernanke’s remarks as a warning of things to come sooner rather than later.

Despite the recent rate increases last week, rates remain historically favorable. Lower rates are not guaranteed and floating in this environment is very risky.

Market Comment
Mortgage bond prices rose last week, pushing mortgage interest rates lower. The Fed spent another $45 billion buying mortgage bonds between November 5th and the 11th. For all the criticism the Fed receives for the handling of the economy, they deserve credit for keeping mortgage interest rates low throughout the year. However, the long term outcome is uncertain. The record Treasury auctions continued to be absorbed in trading without any major problems.

For the week, interest rates improved by about 7/8ths of a discount point.

This Wednesday’s consumer price index data will be the most important release this week. Producer price index data along with retail sales data will set the tone for the start of the week. While inflation indications could hurt mortgage interest rates, signs of tame inflation could help rates improve.

Tax Credit Extension
The housing market received some good news when Congress recently acted on the pleas of housing sector professionals and extended the $8000 first time home buyer tax credit. In addition, the program was expanded to include move-up buyers with a $6500 tax credit. The program now runs through April of next year. Prior to the extension the program was set to eclipse at the end of November. Additional details about the extension can be found here.

Even with the positive measure, the program is criticized for doing nothing to address the foreclosure problems that continue to plague the housing market. Unfortunately, the cost to extend the credit is around $1 billion per month. This has politicians from both sides of the aisle concerned.

The new and move-up buyer incentives coupled with historically low interest rates make now a great time to purchase a home. Low rates also make it favorable for many current homeowners to refinance.