Tuesday, March 15, 2005

The Fed's Take on Real Estate

By Michael Wallace

Federal Reserve Chairman Alan Greenspan has a knack for framing his concerns about sectors of the economy in a simple catchphrase. When he wanted to send a warning about the overheated mid-1990s stock market, he coined the now legendary "irrational exuberance." The phrase this time around, uttered in Greenspan's semi-annual testimony before Congress in February: The interest-rate "conundrum."

The term, which Webster's defines as an "intricate and difficult problem," was meant to sum up the Fed chief's puzzlement as to why longer-term interest rates remained relatively low even as short-term rates have risen. Greenspan suggested that time would ultimately reveal the answer to the riddle, which he expected would prove to be a "short-term aberration."

NO EXUBERANT BUBBLE. But the stubbornly low long-term rates remain a concern. In his speech on fiscal issues before the House Budget Committee in early March, Greenspan offered this observation: "(H)istory cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency, especially since several important economic challenges (Social Security, Medicare, etc.) confront policymakers in the years ahead."

Greenspan's recent remarks were clearly meant to prick up the ears of financial markets. But were they also meant as a shot across the bow of the sizzling housing market? Not likely. The Fed chief appears reluctant to single out the housing sector in his analysis. Far from concluding that housing is an exuberant bubble about to burst, Greenspan suggested that rapid home-price appreciation has boosted wealth and spending power, with household net worth rising above historical averages, despite dismal savings trends.

The Fed chief did caution, however, that a continued rise in household net worth wasn't a foregone conclusion. Also, any future decline in net worth --- e.g., a pullback in housing prices -- would need to be met with rising savings and lower consumption.

The linchpin in the housing sector has been the historically low interest rates of late. The Fed could undoubtedly puncture the sensitive market by accelerating its "measured" pace of rate hikes and continuing to jawbone long-term market yields higher.

But after its brush with deflation in 2003, the Fed may be loath to skewer the status quo on housing. A chain reaction of higher rates, destruction of household wealth, and a plunge in consumption just as business spending is recovering could set off a vicious spiral of foreign capital flight and global recession. With a dual responsibility of curtailing inflation and engineering maximum sustainable growth, this would hardly befit the Fed's charter.

Clearly, the 15% annual surge in home prices nationwide and an astonishing 20% yearly appreciation in metropolitan regions on both coasts aren't sustainable, though prices could plateau at high levels, barring a sharp increase in long-term rates. And the spread of higher housing prices to contiguous and relatively lower-priced regions has been one pervasive trend, as business and human capital migrates next-door, and "the rising tide" thereby lifts all houses.

Compared with past episodes of housing "excesses," several key factors are different now. Homebuilders have done a much better job of managing their inventory. They're more cautious about pre-selling new housing developments. And inventories of new homes have started to rebound as the Fed has begun to snug up short-term rates -- which boosts rates for adjustable-rate mortgages first. Stocks of existing homes are still a far cry from the near double-digit levels of the last national housing decline in the early 1990s.

Data from the Mortgage Bankers Assn. confirm that loans for home purchases have had the edge over refinancings, which have been waning this year. On a seasonally adjusted basis, the group's purchase index hit its highest level so far this calendar year in early March, while the refi index was among the lowest on record.

FIRST TO CRY "UNCLE." Rate-sensitive adjustable-rate mortgages make up about one-third of new applications, and the "high rollers" who have come late to the housing party may be leveraging their purchase of a loftily priced property with an ARM or zero-down-payment mortgage. They'll be the first to cry "uncle" if home prices dip and rates go higher, given the lack of an equity cushion.

For now, overall housing trends remain brisk, though Greenspan & Co. anticipates some slowing in the dramatic appreciation. An economic report issued by Fed Governor Ben Bernanke on Mar. 8 implied as much: "One caveat for the future is that the recent rapid escalation in housing prices -- 11% in 2004, according to the repeat-transactions index constructed by the OFHEO (Office of Federal Housing Enterprise Oversight) -- is unlikely to continue. A plausible scenario is that house prices will either move sideways or rise more slowly during the next few years."

As for upcoming February statistics due later in March, Action Economics expects housing starts to moderate 2.7%, to an annualized pace of 2.1 million, which is still historically firm after large gains at the turn of the year. Existing home sales are projected to dip 1%, to a 6.75 million-unit pace, as a decline in the new pending home sales index suggests some cooling off. We expect a sizable rebound in new home sales, however, after a 9.2% drop in January and a round of upward revisions to past data.

In short, the housing data in February should receive support from low interest rates, an improved labor market, and better weather compared with January. "Conundrum" or not, the housing market should still have the wind at its back.

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