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The Fed is in a difficult situation as it is scheduled to halt its purchases of mortgage securities (also known as quantitative easing or creating cash and using it to buy mortgage securities) by March 31st 2010.

Currently, the asset side of their balance sheet shows $2.255 trillion in assets owned. (Source: FRB H.4.1 January 21, 2010). Securities it holds outright stand at $1.906 trillion up a monstrous $1.401 trillion from the period January 21, 2009. Of the increase, its Treasury holdings have increased by $301 billion and its Federal Agency debt securities by $137 billion.

The largest increase in its holdings though came from mortgage backed securities (defined in the Fed footnotes as the face value of securities from Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae) which increased by $963 billion from the same period a year earlier.

Also of note, is that the Fed increased its mortgage backed securities holdings by $49 billion for the most recent one week period ahead of its pace for the remainder of the program.

So the Fed has about $250 billion left in its scheduled $1.25 trillion of the mortgage bonds from Fannie and Freddie purchases it allocated back when it began its quantitative easing. That comes out to about $125 billion for each of February 2010 and March 2010 or about $25 billion per week; about half of the amount the Fed increased its holdings by last week.

But the large looming question that has to be addressed is what does the Fed do regarding these purchases? What is next? Does the Fed halt its purchases as scheduled? If it does, what happens to the mortgage market? The Fed is the 800 pound gorilla-like purchaser in the market. If it exits, how far will interest rates rise? Or, will it extend the amount it is allowed to purchase and the time limit as well. These questions are very likely being addressed at the meeting this week.

Also, the political realm has to be looked at. The quantitative easing strategy has proponents and opponents in Washington. Some think Q.E. is chicanery and is something that central banks in third world countries resort to. Others in DC think it is the correct strategy and should be extended.

Scenario 1 – The Fed Stays on Schedule: Quantitative Easing Ends March 31st 2010

In this scenario, the Fed stops its purchases of mortgages. The Fed is the giant buyer in the mortgage market. At the very recent pace of $50 billion per week or $10 billion per day, the Fed was continuously on the bid side of the market. Who else on the planet can replace such a daily bid? I would hazard a guess that no one.

So, what happens to the mortgage market? I would assume rates would go up in this case. Currently, the average 30 year fixed mortgage from Freddie Mac is 4.99%. Could the 30 year mortgage go up to 5.50%? That is foreseeable. What about 6% or higher? Well, higher rates may move in line only if the real economy picks up as well. So a 6% or higher 30 year fixed Freddie Mac rate may not hurt too much if the economy is doing well but 5.50% looks like it has potential. This would appease some in DC not in approval of Q.E.

Scenario #2 – The Fed Extends Quantitative Easing

In this scenario, the Fed decides, that the economy is not strong enough for the Fed to stop purchasing mortgage securities, so it extends the time period by a 3 to 6 month period depending on how the economy does. It also increases the amount by $300 billion to $600 billion to cover that extra 3 to 6 months. This of course would be stimulative to the economy and potentially create further inflation than the existing quantitative easing strategy would. Mortgage rates would likely stay low as long as the market believes inflation will remain tame. If the market ever got a feeling that inflation were coming back, then this strategy could backfire. This strategy would appease those in DC that think the Fed should be doing as much as possible to help the economy.

Looking further at the political climate throws a monkey wrench into this whole scheme as well. Ben Bernanke is up for re-election. This is to take place before this coming Sunday, January 31st. The Fed has its two day meeting ending this Wednesday the 27th followed by the release of its statement. Market participants as always will be examining the statement closely.

But, political figures will also be tuning in to see what the Fed decides to do with the quantitative easing. The Fed is supposed to be non-political. However, even the most non-biased of employees (as I assume Bernanke is) has to understand the consequences of the Fed being seen as easing off on stimulative policies when the economy is struggling to get its legs at a time when the Fed chair is up for re-election.

This will be an interesting battle as the Fed could even put off its decision about further extending quantitative easing until the next meeting in 6 weeks. My thoughts are that the economy is still fragile enough that a good case for extending quantitative easing can be made, and I would guess that the Fed may make that known this time. Creating cash out of thin air and then financing the budget gap and artificially keeping interest rates low is scary stuff, but the alternative of a prolonged Japanese style deflationary down turn is still a possibility and the Fed will likely err against that risk.

The more that I think about the $49 billion in mortgage purchases over the most recent week, it seems that it is possible the Fed is prepared to extend it. That is a rather large sum and is twice the pace they are scheduled to keep for the remainder of the quantitative easing period. So maybe, the odds favor the potential for some type of extension of quantitative easing. As I wrote above, this Fed statement on Wednesday should generate a lot of attention!

Written by Tom Henderson.

Disclosure: There are no disclosures to make.

Source: Fed Likely to Extend Quantitative Easing