Will the Fed's New Policies Revitalize the Housing Market?

New refinancing activity and additional sales could help to strengthen the economic recovery

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Congress is gridlocked, consumers are pessimistic, and firms are barely hiring. To speed this recovery up -- or to prevent a double dip -- it might be up to the Federal Reserve. Last week it announced its latest attempt to revitalize the economy. Its chief target appears to be the still anemic housing market. Will the new policies work?

The Fed's Plan

The central bank will take two different actions meant to jumpstart the economy. First, there's "Operation Twist." The Fed will attempt to push down long-term interest rates by purchasing $400 billion in Treasury securities with six to 30 year terms. The program will last for nine months -- through June 2012.

But here's the clever part: the Fed will sell shorter-dated Treasuries in exchange for bank reserves. This will prevent the Fed from having to expand its balance sheet to purchase longer-term Treasury securities. The relative increase in short term rates should be small, since short-term Treasuries are in high demand and the Fed is keeping other short-term rates low through its other policies.

The Fed announced another policy change as well. It has been reinvesting its maturing principal in additional Treasury securities. The central bank will refine that approach by investing maturing principal from its agency bonds and mortgage-backed securities in additional agency mortgage-backed securities. In this way, it will keep the size of its mortgage securities exposure level. But more importantly, this action will also increase the demand for mortgage-backed securities, which should push down mortgage interest rates.

The Medicine the Housing Market Needs?

In fact, the major target for all of the Fed's new action appears to be the U.S. housing market. Both Operation Twist and the new MBS reinvestment policy should help to push down mortgage interest rates. And they're low already: this week Freddie Mac reports the average 30-year mortgage interest rate at just 4.09%. Through the Fed's new policy, rates should easily dip below 4%.

Operation Twist could also help the reinvestment policy to have a more dramatic effect: as mortgage interest rates begin to decline, we should see mortgage refinancing soar. That means more maturing principal, which will provide even more capital for the Fed to reinvest in MBS to push down mortgage interest rates even further.

One question outstanding is whether the government will create a headwind or a tailwind for the Fed effort. If it decides to respond to Operation Twist by issuing more longer-term Treasuries, then this will partially neutralize its effect: additional supply would soak up some of the new demand the Fed is creating. But it might be hard for the government to ignore the opportunity to get more ultra-cheap long-term financing, particularly given the nation's precarious debt situation.

But we do know that the Obama administration was pushing for more mortgage refinancing even before the Fed action was announced. If the Federal Housing Finance Authority goes along, then more Americans with loans owned by Fannie Mae and Freddie Mac will get the opportunity to refinance at ultra-low rates.

But Will It Boost the Economy?

If mortgage interest rates decline significantly, then we'll almost certainly see more refinancing occur. That will provide a little bit of stimulus. Some Americans will lower their monthly mortgage payment. The impact that this has on the economy depends on how much these payments are lowered and how many people take advantage of the opportunity. That additional money they'll have can then be spent to stimulate the economy.

What's less clear, however, is whether or not the very low mortgage interest rates will lead to more home sales. Over the past year, even though interest rates were extremely low, they weren't enough to push more buyers into the market. Will even lower rates do the trick?

If home sales do increase, then prices may begin to stabilize -- at least for a time. If the market isn't near the bottom, then once interest rates begin rising again, sales could decline and prices could begin to drop again. This is what we saw when the home buyer credit created a temporary burst of demand.

What we probably won't see is a significant increase in construction. The market still has plenty of existing inventory to work through before more homes are needed. So unless home demand truly explodes, we shouldn't expect a tidal wave of construction jobs.

As always, the effectiveness of the Fed's policy relies on the willingness of consumers, banks, and businesses to play along. First, Americans will need to seek refinancing and home purchases. Then, the banks must be willing to provide the credit for those new loans. If that encourages more spending due to consumers having more money in their pockets, then firms could begin hiring more aggressively. That's the plan -- we'll see if it works.

Image Credit: Joshua Lott/Reuters