The Fed’s outlook and views on inflation and deflation
While it isn’t discussed that much, the Fed does have a dual mandate to contain inflation as well as support employment growth. Historically, this has meant that the Fed must maintain interest rates such that it controls inflation. However, the Fed has set an inflation target of 2%, and lately, inflation has come in below that number. It’s important to remember that while the Fed fears inflation, it fears deflation more. This is because when interest rates are at the zero bound, deflation raises real interest rates. So the Fed will pull out all the stops trying to prevent that.
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Yellen made the following comments in her prepared remarks:
Implications for mortgage REITs
The low inflation levels give the Fed a reason to hold interest rates low for longer. Even once quantitative easing ends, as long as the short end of the yield curve remains anchored (and this is what the Fed does when it manipulates the Federal Funds rate), the long end of the curve will have somewhat of a ceiling on rates. We rarely see a differential between the Fed Funds rate and the ten-year bond in excess of 4%. This will put a bit of a floor under mortgage-backed securities, which is good news for agency REITs like Annaly Capital (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Hatteras (HTS), and Capstead (CMO).
To learn more about the outlook for mortgage REITs, see the Market Realist series The right direction: December LPS Mortgage Monitor takeaways.