The Fed's Shift in Policy: The Mortgage Industry Is Poised for a Hit from Higher Interest Rates in 2005. Here's Some Insight into the Fed's Thinking as It Reacts to Economic News and Positions Itself to Move Rates Higher in the Months Ahead

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THE FEDERAL OPEN MARKET COMMITTEE (FOMC), the arm of the Federal Reserve that sets interest rate policy, earlier this spring set a new course to restore the central bank's monetary policy stance to neutrality. For four years, it has pursued a policy of accommodation in the face of a series of threats to the economy: recession; rising unemployment; 9/11 and its economic aftermath; corporate accounting scandals of 2002 with their market fallout; and worries about deflation in 2003.

With the economy showing signs of inflation since early this year, fears the Fed held previously that prices might fall (deflation) were largely dispelled. Throw in a strengthening economy, rising profits and significant improvements in the number of new payroll jobs, and the FOMC found by its May 4 meeting that conditions suggest it is time to change the course of monetary policy.

In its characteristically brief style, the FOMC stated after its May meeting that it "believes that policy accommodation can be removed at a pace that is likely to be measured."

The key question for Fed watchers and mortgage bankers is how will the FOMC go about charting its course and, in turn, how will that affect interest rates, the mortgage market and the economy? More specifically, what is meant by "measured," and how rapid and how big will be the steps the FOMC plans to take to reach its goal of neutrality?

In July, Sen. Richard Shelby (R-Alabama), chairman of the Banking, Housing and Urban Affairs Committee, asked Federal Reserve Chairman Alan Greenspan to explain further what the FOMC meant by a "measured pace" when Greenspan gave his semiannual report on monetary policy. Characteristically, Greenspan answered in an indirect way that revealed some key elements of his thinking, but also left out considerable detail.

"[I]f we are to maintain the mandate which the Congress has given us to create price stability, mainly for the purpose of maintaining and fostering maximum sustainable long-term growth--because that's our objective--we will do what is required to achieve that objective," Greenspan told Shelby.

Greenspan shed light on this point in his prepared remarks, in which he laid out two potential general scenarios the Fed might follow: one measured and the other dynamic. Here's the money quote: "If economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates."

Or, to paraphrase, the Fed is planning a gradual increase in interest rates, but if conditions warrant, it could become a bumpy ride. And, by the way, the chairman implied, if this approach is necessary, the economy will be strong enough to take a bumpy ride.

The Fed's anticipated gradualist approach to higher interest rates contrasts with its approach a decade ago. Back in February 1994, the markets were surprised by the Fed's interest rate increase that came at a time of accelerating economic growth.

Back then, after the Fed announced a quarter-point rate increase in the target for the federal funds rate (from 3 percent to 3 1/4 percent), the bond market plummeted while interest rates jumped across the yield curve. A series of additional interest rate increases followed as the Fed fought an incipient spike in inflation, pushing the economy into a slowdown that came close to being a recession.

"In effect, they're telling us that it's not 1994 all over again," explains Bob Hormats, vice chairman of Goldman Sachs International, New York. "Back then the Fed thought it was behind the curve. They were worried they had fallen behind and had to catch up. …