As inflation decelerates, the dollar continues on its steady ascendency to the throne, portending the much-feared arrival of consumer deflation.

Treasury bond (T-bond) yields, which directly affect mortgage rates, dropped-off after the Federal Reserve announced inflation has fallen to dangerously low rates, signaling the need for further intervention from the Fed in order to mitigate the risk of impending consumer deflation. [For more information of the perils of deflation, see the October 2010 first tuesday article, Deflation’s push on the real estate recovery.]

10-year Treasury note (T-note) yields, upon which fixed rates for 30-year mortgages are set at generally 1.4% higher, have dropped dramatically to 2.52%. Two-year T-note yields have fallen to record lows in October, hovering near .38% and declining.

With the core consumer price index registering a mere 0.9% for the last five months and dropping, the Fed is becoming increasingly nervous of what appears to be inevitable deflation. The Fed has pledged it will do whatever is necessary to ensure the overall health of the economy, which requires maintaining a minimum level of consumer inflation. The Fed’s actions will include the purchase of vast amounts of Treasury bonds in order to fuel the much-needed inflation by stimulating consumer lending.

first tuesday take:. The Fed has three responsibilities: distribute sufficient money into circulation, keep the labor market stable and maintain a proper level of inflation (2-3% is the time-honored target). Right now the Fed has a diminishing supply of monetary weapons to wield in the fight to attain these goals and they are left to act with the Treasury, as Congress is in rigor mortis, unable to enact the needed stimulus to directly create jobs and induce bank lending. It has thus far not been successful in controlling the rate of inflation by simply lowering interest rates. Inflation will not rise to healthy levels until consumers start spending money once again or the supply-siders lose influence.

Lenders are behaving in the same fashion as consumers — they are hoarding funds and only engaging in the lowest risk ventures possible. This means they lend to the government using zero-cost government borrowed money held in their massive cash reserves, thus eliminating virtually all risk and turning a healthy 3-4% annual return. Until now, lenders have had no motivation to lend money to a higher-risk borrower in the consumer market when they are reaping the rewards of their cozy relationship with government agencies.

The Fed’s decision to buy mega-billions of dollars worth of 30-year T-bonds to invigorate consumer spending is unprecedented in the U.S. (Japan was unsuccessful with quantitative easing in the early 2000s). When purchasing long-term T-bonds at higher prices than the banks are willing to pay, the Fed will continue lending to banks at the virtually 0% interest rate that is integral to maintaining lender solvency. They will, however, simultaneously and indirectly lower interest rates for consumers since reduced earnings on bonds will force lenders to lend to the consumer again.

What are the implications of this strategy for the real estate market? Real estate prices are now set to trend lower and will do so for some time as lenders reluctantly foreclose and declare their losses as shadow inventory is resold on the market.

Real estate prices will not stabilize by 2011 for two main reasons: lack of consumer confidence (read: hoarding) and the present unwillingness of lenders to make consumer and small business loans with 100% government guarantees. The Fed’s decision to dominate the T-bond market will force lenders to start making loans again to those on California’s Main Street. In turn, consumers will soon regain their confidence as they qualify for loans and start buying houses again. [For more information of consumer confidence in the real estate market, see the May 2010 first tuesday article, Homebuyers feel ready and willing to buy, but not financially able.]

Re: “Fed makes clear that it wants to boost inflation” from the Los Angeles Times