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Fed keeps focus firmly on inflation

By's John W. Schoen
/ Source:

Despite recent reports showing no end to the housing slump and bond market jitters that have pushed long-term interest rates higher, simmering inflation is still the main focus at the Federal Reserve, policymakers confirmed Thursday.

And it likely will remain so as long as the U.S. economy keeps growing at a healthy clip.

Long-term interest rates have been rising recently amid turmoil for investors in the riskiest corners of the mortgage market, but the Fed’s steady-as-she goes policy for short-term rates seems to be working. Fed Chairman Ben Bernanke and his colleagues renewed that policy as their two-day midyear meeting  wrapped up Thursday.

In a statement after the meeting of the Fed's Open Market Committee, central bankers said, "sustained moderation in inflation pressures has yet to be convincingly demonstrated.” The group left the benchmark overnight rate unchanged at 5.25 percent.

Though energy and food prices have been rising this year, the “core” price gauge the Fed follows closely has been easing. The latest data, for April, show prices excluding those volatile categories rising at a 2 percent rate — the upper end of the range the Fed is widely believed to be targeting.

Still, Fed officials have stressed they fear prices could pick up speed again, especially if higher energy costs begin to push up the costs of other goods. Higher corn prices, in part the result of strong demand due to rapidly expanding ethanol production, also could spill over into other food prices. All of which has kept central bankers worried, at least in public, about keeping inflation under control.

"Although core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside,” Fed Chairman Ben Bernanke said in a June 5 speech.

But the Fed has also been keeping a close watch on the widening slump in the housing market, which has gone from bad to worse since the Fed’s last meeting in May. Home prices and sales activity keep falling. Lenders have tightened borrowing standards. As defaults and foreclosures have risen, the bond market — which determines long-term interest rates including mortgage rates — has demanded higher rates to make up for the risk that more borrowers may default.

Still, while recent headlines of big losses on mortgage-backed bonds have given investors the jitters, the problems in the mortgage market haven’t risen to a level that will prompt the Fed to act, according to Stuart Hoffman, chief economist at PNC Financial Services Group.

“There are definitely people getting burned, and bad decisions have been made," he said. “But at this point it seems to be more private pain — both for the borrowers and for the lenders — than it is public pain. From the Fed's point of view, they’re still going to focus on inflation and the general well-being of the economy in their mandate.”

After barely moving forward in the first quarter of the year, the economy picked up steam in the quarter just coming to a close, with consumers spending at a healthy clip and businesses boosting hiring and investment.

As long as the economy continues to post steady growth, the Fed is likely to maintain its guard and focus on the risk of higher inflation.

"Certainly the business sector has returned decisively to expansion mode," said Julia Coronado, a senior economist at Barclays Capital. "The housing sector is still uncertain, but given where we are in the labor market, any pickup in growth by definition means higher pressures on inflation."

The financial markets were rocked last week by news of the near-collapse of two Bear Stearns hedge funds — both of which were big holders of shaky subprime mortgage bonds. Losses by those funds, and the murky nature of the mortgage bond market, left investors speculating on whether wider losses could spill over into the broader credit markets.

So far, the damage appears to be contained. Wall Street is relying on a system of credit firewalls that have been built into mortgage-backed securities — the pools of bonds that are created to slice up the risk of default — paying the highest returns to those who take on the most risk.

Instead of owning mortgages directly, investors buy separate bonds backed by mortgage payments. These new bonds come in different classes; holders of the highest-rated bonds get paid first. That way, even if most of the underlying loans go bad, the top-rated bondholders won’t lose money. Investors who buy the riskiest bonds — like those that are now showing the biggest losses — get the highest returns but are the first to get hit when defaults start rising.

To provide further protection for investors, some mortgage-backed bonds pay out lower interest rates to bond holders than the interest rate they take in from the underlying loans.

“That spread — that interest rate differential between what people are paying (on their mortgages) — and what the bonds are expected to pay — that can be used to cover losses,” said Susan Barnes, head of residential mortgage-backed securities ratings at Standard & Poors.

If mortgage payments come through faster than expected, the extra money can be used to pay off bonds faster than planned. That also helps offset the risk of any future defaults on the underlying mortgages.

So far, despite the high profile collapse of the subprime mortgage market, the fire walls seem to be holding. Though the total losses from mortgage defaults may eventually run into the billions, both Moody's and Standard and Poors say the riskiest paper represents less than 2 percent of all mortgage-backed securities.

Investors and central bankers are keeping a close lookout for signs that the subprime mortgage mess is spreading to the wider credit markets, which continue to amass huge pools of capital for a record pace of deal making. By historical measures, that capital is about as cheap and plentiful as it gets. The worry is that the nervousness in the mortgage market prompts lenders and investors to pull back on providing that capital — sharply reducing the amount of “liquidity” in the financial system.

“You don’t see that,” said Hoffman. “You hear tales about maybe on the edges some deals are going to be more costly in term of rates. But you don’t see any real signs of a liquidity squeeze.”