With inflation rates lingering just below 2% and unemployment still far away from the 6.5% goal, the Federal Reserve is set on buying more agency mortgage-backed securities and Treasurys past market projections, analysts claim.

However, when the time comes to begin tapering the central bank’s open-ended third round of quantitative easing, the Fed is likely to taper off Treasury purchases first, as there is a widespread belief that the stimulative per-dollar effect of MBS purchases is larger, Goldman Sachs (GS) said in its latest report.

Additionally, the housing market continues on its uphill trajectory into recovery and with home prices rising, foreclosure inventories shrinking and mortgage rates hovering near record lows, the central bank has a laundry list of advantages to keep rolling in MBS purchases.

“According to the March FOMC minutes, ‘a few participants felt that MBS purchases provided more support to the economy than purchases of longer-term Treasury securities because they stimulated the housing sector directly,'” said Jan Hatzius of Goldman Sachs.

He added, “Although the minutes also note that ‘a few preferred to focus any purchases in the Treasury market to avoid allocating credit to a specific sector of the economy,’ the former group is likely to be closer to the views of the FOMC leadership.”

Although there has been significant chatter on Capitol Hill due to the Federal Reserve announcing a strategy to exit its bond-buying program, there is little new information on the key question, namely the timing of any tapering moves.

As a result, Goldman Sachs is sticking to its original forecast and believes the central bank will continue purchases at $85 billion a month through 2013, follow by a gradual tapering process toward zero that starts in the first quarter of 2014, which will be announced at the December Federal Open Market Committee meeting. 

“This is based on our forecast that read gross domestic product will grow 2% in the second quarter and third quarter of this year and 2.5% in the fourth quarter, the unemployment rate will fall to 7.3% by the end of 2013, and core personal consumption expenditures inflation will edge up a bit to 1.3% year-on-year by the fourth quarter,” analysts for Goldman Sachs explained.

While the Federal Reserve increasing their monthly bond purchases seems quite unlikely, there are various factors that could prompt the central bank to increase the size of its quantitative easing program. 

These factors include a clear downturn in the economy with a renewed risk of recession or a substantial decline core PCE and consumer price index inflation as well as inflation expectations.

“If the labor market and economic recovery remained a little more sluggish than our forecast and underlying inflation trends moved any lower than the current 1.25% rate, we believe that the start date would move into 2014, with an announcement at the March meeting or later,” Goldman Sachs concluded. 


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