Are Zero Percent Interest Rates Ahead?

There was a headline in Barron’s recently which no doubt raised a few eyebrows. “Fed Setting Long-Range Goal of 0% Real Interest Rates,” it said, a figure which is hard to ignore.

With most pundits predicting that the Fed will raise bank rates by .25 percent in December, the Barron’s headline seems to be saying that rates are actually headed lower. Given that Barron’s is one of our leading financial journals how is this possible? If the Fed follows widespread — but not universal — predictions and raises rates in December then why would Barron’s say that the goal is zero interest rates?

The answer is both interesting and troubling.

Imagine that you’re an investor with $1 million in cash. You could take that money and invest it in any number of ways. However, in looking at risk and reward and the possibility that future interest rates could be significantly higher than what we see today you decide to put your money into shorter-term investments with a 2 percent yield.

We could look at this transaction and see that the investor has a $20,000 per year cash return. We could also look at the same transaction and say that the inflation rate is 2 percent. What we now have is an investment which produces $20,000 per year but since the value of money has fallen by 2 percent the real return after inflation is zero because the investor’s buying power has not increased.

“Money for nothing sounds good and helps stocks and bonds,” said Barron’s, but it’s a symptom of the economy’s dire straits.”

According to Barron’s, “the long-anticipated rise in interest rates is likely to be far smaller and gentler than the conventional wisdom embodied in the forecasts of the great majority of economists and analysts. In actuality, the long-run real cost of money probably is zero percent, after inflation is deducted, according to a key Fed study discussed at the meeting.”

If we begin to think about wealth in terms of buying power instead of cash dollars then the economic picture becomes much clearer — maybe too clear.

Real Estate Profits

Look at real estate values.

The National Association of Realtors says “the median existing-home price for all housing types in September was $221,900, which is 6.1 percent above September 2014 ($209,100). September’s price increase marks the 43rd consecutive month of year-over-year gains.”

Not to be outdone, the Federal Housing Finance Agency (FHFA) says in August, the latest month available, saw home values rise to a point where they are now just .9 percent below their March 2007 peak.

In other words, in the next six months or a year it’s likely that home prices will reach new historic highs nationwide, at least on a cash basis. Politicians will crow and homeowners will have billions of dollars in new equity.

This sounds great, but what about those “dire straits” mentioned by Barron’s.

Let’s go back to the investor who is taking in that hefty 0 percent return. In that case we looked at the value of the asset, $1 million, figured the annual return, 2 percent, and subtracted lost buying power — 2 percent — to see what the investment really generated.

If we try the same approach with real estate pricing the numbers look like this:

Back in June 2007, the median sale price of an existing home was $229,000 according to NAR statistics. The Bureau of Labor Statistics says that because of inflation it will take $262,681 in today’s dollars to buy the same goods and services as $229,000 in 2007.

Now, unfortunately, typical homes today do not cost $263,000 or anywhere close. This tells us that real estate remains a huge bargain both in terms of cheap pricing and mortgage rates, rates which are now about 4 percent.

If you’re an investor who purchased in 2007 for $229,000 and then — after closing costs and marketing expenses — sell in 2015 for $262,681 it would seem that you come out even. Your buying power is stable but the government, in its wisdom, taxes investor “profits,” that extra $33,681 in this example. Subtract the money paid for sale and depreciation recapture taxes and now you have a buying power loss. Hopefully, the investor did better than a break-even return.

Would it make sense to be a renter in a 0 percent economy? Owners generally have equity as a result of mortgage amortization over time and tax benefits, advantages unavailable to renters. Imagine that Smith and Jones both pay $1,500 for shelter. Smith owns and has a fixed-rate mortgage. Jones rents. After 30 years Smith owns his property free and clear while Jones has had to contend with decades of rising rental rates. Seen another way, the children of Smith have lots to inherit while the children of Jones do not benefit from real estate equity or the tax advantages of ownership.

In a 0 percent economy there has to be a way to accumulate additional buying power and there is. For instance, if a real estate investor picks wisely and is rewarded with higher rental rates and appreciation above the rate of inflation then it becomes possible to generate significant profits which increase buying power and thus real wealth.

Less Than Zero

The Federal Reserve and other central banks use their ability to set interest rates as a lever to move the economy. The stated goal is to obtain full employment while limiting inflation, but in practice central planning inherently creates winners and losers. The Fed’s “zero interest rate policy” — ZIRP — has quashed retirement accounts and demolished bond returns while at the same time elating homeowners in search of a mortgage and corporate borrowers who want to expand.

But with interest rates so low, the Fed does not have much room for manipulation. The ability to move rates higher is limited by the reality that an estimated $3.6 trillion overseas is now invested at negative interest, a by-product of the policies of other central banks. Alternatively, the Fed might press into uncharted territory and actually adopt NIRP – a negative interest-rate policy.

“Central banks,” explains a an October paper co-authored by John C. Williams, the President and CEO of the Federal Reserve Bank of San Francisco, “could aim to reduce nominal interest rates below zero, as has been done to a limited extent in several European jurisdictions. Even though a number of institutional hurdles may make it difficult to reduce nominal interest rates to levels that might be called for in response to a major recession, negative short-term interest rates in combination with forward guidance and asset purchases would provide central banks with a potent set of tools to respond to undesirably low inflation and economic weakness.”

The catch is that interest rates in the U.S. have essentially been at zero since 2008 and the definition of “short term” may be a lot longer than many people expect.

Bill Gross, the lead portfolio manager at Janus Capital explained in his November 2015 commentary that if “bond investors become increasingly convinced that policy rates will remain close to 0 percent for an ‘extended period of time’, then yield curves flatten; 5, 10, and 30 year bonds move lower in yield, which at first blush would seem to be positive for economic expansion (reducing mortgage rates and such). It would seem that lower borrowing costs in historical logic should cause companies and households to borrow and spend more. The post-Lehman experience, as well as the lost decades of Japan, however, show that they may not, if these longer term yields are close to the zero bound.”

Gross adds that “when our modern financial system can no longer find profitable outlets for the credit it creates, it has a tendency to slow and begin to inhibit economic and profit growth in the overall economy. With a near zero interest rate policy, central banks zero out the cost of time, bidding up existing asset prices, but failing to create sufficient new assets in the real economy.”

If Gross is correct we could be in for a decades-long period of financial inertia, a time when interest rates are stuck around zero and maybe below. It’s the financial equivalent of giving a party and nobody comes only in this case we have huge amounts of capital at low rates that no one wants to borrow.

In such an environment owning real estate at least presents the opportunity to convert debt to equity through amortization, tax benefits and the possibility of appreciation. That may not seem like a great return when compared with past decades, but hanging on in the new era is likely to be a far-better strategy than renting and no equity at all.

——

To search and research real estate data for more than 130 million properties nationwide, sign up for a FREE trial to RealtyTrac.

For the latest real estate news and trends get a FREE issue of our award-winning real estate newsletter, the Housing News Report.

——

Related News
Could We See Negative Interest Rates?
Why The Fed Fears Higher Interest Rates
Debt Shakes The World Economy — And Mortgage Rates

To search and research real estate data for more than 130 million properties nationwide, sign up for a FREE trial to RealtyTrac.

For the latest real estate news and trends get a FREE issue of our award-winning real estate newsletter, the Housing News Report.

Related Posts

Leave a Reply

Copyright © 2016 Renwood RealtyTrac LLC - All rights reserved