Monetary Policy

The Fed issued its FOMC policy statement today. Its intent is to keep short rates low all
the way out to late 2014 and to be on standby to provide increased monetary liquidity if
the economic recovery falters.

Post WW 2 indicators are now 75% in favor of the Fed raising short rates. Only capacity
utilization is below the threshold, and that by a scant 1.5 percentage points. But, the Fed has
fears. My broad credit driven measure of funding liquidity is up only 4.3% yr / yr. and about
80% of that increase is attributable to the prior QE 2 program of liquidity injection. In turn,
even with much improved housing affordability, banks and mortgage financiers are heavily
shading lending decisions in favor of collateral value rather than cash flow adequacy and
stability. Raising short rates would trigger long rate increases in the short run. That
would make mortgages more expensive, reduce housing affordability and could scare the
banks into even more conservative lending practice. This all would increase the supply of
housing on the market and introduce more intense deflationary pressure.

With a platform of low interest rates, the Fed is banking on an eventual recovery of the
housing market as well as a continuation of a non-residential construction upturn. Stronger
housing and real estate financing needs would expand credit driven liquidity in the economy
and reduce the need by the Fed to resort to quantitative easing. It would ultimately force
lenders to compete more aggressively for funding and begin to put upward pressure on
market short rates. As of now, the Fed thinks this process could take another two years before
private sector credit demand is robust enough to warrant more constrictive monetary policy.

Of course, if the housing / construction markets stage a stronger than expected recovery and
if it comes sooner than the Fed anticipates, well then you can kiss ZIRP to late 2014 good bye.