Will the big bad Fed blow your house down?

August 3, 2006

The economy is at a crossroads. Inflation is increasing and economic growth is slowing. The Federal Reserve knows they created inflation with their recent stint of economic stimulus, but is worried attempts to cool the economy could cause a major recession. If they take a wait and see stance, inflation could spiral out of control even with a slow economy – the dreaded stagflation of the 1970s and early 80s that everybody thought could never happen again.

How this plays out could have a dramatic effect on mutual fund investments, but particularly real estate wealth.

The Federal Reserve tries to keep inflation steady and low, while fine-tuning the economy to operate at or near the mysterious maximum sustainable growth rate.

The Fed likes to pretend they don’t try to prick bubbles in assets, be it stocks or beachfront condos, but they do. In other words, they won’t say, <i>“Condo prices are up 100% in 2 years. The sharp rise in home prices is leading to dangerous speculative behavior, excessive borrowing, and low savings rates. If home prices go much higher, there could be big trouble if prices correct sharply; let’s send prices back to earth with 7% short-term interest rates”</i>.  

They do say, <i>“In the interest of stable prices, let’s try to cool down the economy.”</i> The Fed is not targeting home prices, but home prices cause the economy to be hot or cold. They hope cooling the economy will slow the growth in home prices.

The trouble is similar to the one in 1999 with stocks. Back in 1999 the Federal Reserve knew the stock market was overheated. Though inflation was low, the Fed took steps to cool the economy, which included jacking up interest rates. They claimed it was to slow a too-hot economy that would certainly someday, eventually, likely, lead to inflation. Such a preemptive strike against inflation was uncalled for and certainly not their true concern. The Fed was afraid of a future stock market crash and economic contraction that could lead to a depression. 

As noted in the minutes (meeting notes) to an early 2000 Fed meeting, ”Of key importance was the prospective performance of the stock market, whose robust gains in recent years had undoubtedly boosted consumer confidence and spending. The members noted that equity prices generally had posted further gains during the intermeeting period, but in their view the large increases of recent years were not likely to be repeated, and an absence of such gains would have a restraining effect on consumer expenditures over time…”

The Fed needed to end stock market speculation by cooling the boundless profitability of corporate America and limitless investor optimism. It worked. The economy fell into a recession and the stock market plummeted, particularly speculative areas of the market, which fell around 75% on average. 

Stocks fell before the economy. In fact, by any measures the recession that started in 2001 was pretty mild. The Fed acted like it was the Great Depression 2.0 and promptly lowered interest rates to 40-year lows. They started talking of deflation – just a few months after supposed inflation fears lead them to raise rates. Why? 

The Fed quickly moved to the opposite assessment they held in 1999 – that a crashing stock market would lead to a draining wealth effect on consumers. People would hunker down in the safety of cash and worry that their retirement was in jeopardy and actually start saving as a way to fund retirement goals. Such a dramatic switch would lead to a further economic slowdown. A depression-forming snowball would be set in motion.

By 2002 Fed members voiced concerns at meetings such as, “…the cumulative losses in financial wealth incurred since early 2000 clearly were having an adverse impact on expenditures by households and the higher cost of equity capital was inhibiting business investment. The declines in equity prices had been accompanied by a heightened degree of risk aversion that had led to widened credit spreads in financial markets and the curtailment of credit availability to potential borrowers whose repayment prospects were viewed as questionable…”

By lowering interest rates to below-inflation levels, consumers were encouraged to borrow big. Investors were paid next to nothing for safe investments, and encouraged to speculate for above inflation returns. Even those “whose repayment prospects were viewed as questionable” found loans easy to come by. 

The Fed has a lot of nerve noting that we have such a poor savings rate – if they left interest rates at 5% and didn’t inflate home prices 100% (higher in some areas) our savings rate would be much higher. Why scrimp to save $500 a month when your home climbs $100,000 a year in value?

One potential (but extremely unlikely) depression was averted by boosting homes to cover the losses in stocks. Household wealth today (including stocks and housing equity) is even higher than the boom times in stocks. As noted in Fed meetings, <i>“…for many households, the negative wealth effects stemming from losses on equities were offset, at least to some extent, by continuing increases in home equity values…”</i>

Now the Fed is faced with the true conundrum: how do you cool the economy to pinch the home bubble without causing another crash (this time in homes) and near-economic death? The Fed probably knows the next crash will be harder to asset bubble our way out of.

Trouble is, pricking asset bubbles is difficult to nearly impossible. All sorts of economic activity can dry up before speculation slows. One reason the late 1920s Fed could not pinch the stock bubble effectively was because efforts to rein in the market hurt the economy first. Lifting interest rates would stop people from taking out loans to expand their business or to buy a home or car, but not from buying stocks on margin.

Even today we see the effects of rising rates on “real economy” purchases BEFORE “speculative economy” behavior. As soon as rates crept up from near zero, car buying slowed – but not condo buying. Why do people balk at a 1% higher borrowing rate when buying a $20,000 car but not at a $500,000 condo? Simple: the condo will be worth $1,000,000 in “a few years”, so what’s 1% extra give or take?

Through seventeen interest rate increases housing prices have yet to dip. Meanwhile, auto sales are lackluster, Dell and Intel are saying computer sales are slowing down, and big box retailers are worried about the future. 

Fortunately for the Fed it seems home price appreciation has finally stopped. Inventories of unsold homes are increasing significantly and orders for new homes are falling. The home boom is over. The Fed hopes inflation pressures will now ease, commodity prices will fall, but the economy will remain on solid footing – the story will have a happy ending.

It’s entirely possible the Fed has already sown the seeds of a recession. Maybe they had to stop the home price money train before it became a wreck. Hopefully we’ll just get a mild recession or just a slowdown in economic growth and a minor pullback in home prices. 

That’s the trouble with pricking bubbles – you gotta kill the economy to wound the housing market.