Inflation by some measures may be back and if that’s the case all bets for increased real estate sales are off.
“Underlying U.S. inflation appears to be firming despite slower economic growth,” says The Wall Street Journal, “a potentially reassuring sign for the Federal Reserve as it weighs when to start raising interest rates.”
Meanwhile, on the same day as the Journal report, the National Association of Realtors explained that “in March the ‘core inflation’ was 1.8 percent. This increase is still within the Fed’s comfort zone of keeping the inflation lid at 2 percent. So the Fed need not be in a hurry to raise interest rates — at least not yet.”
So which is it? Rising inflation that matters or rising inflation that has no material impact? The answer is important because if inflation increases are real then so is the possibility of higher interest rates from the Fed, steeper mortgage rates and fewer home sales.
The Fed Shrugs
It’s hard to imagine that anyone at the Fed is “re-assured” about inflation, a better expression might be “terrified.”
The fact is that the Fed has had two chances to raise interest rates last year and whiffed on both.
First, mortgage rates rose in 2014 on the rumor of an end to the Fed’s quantitative easing program, the monthly purchase of securities worth billions of dollars. Then, when QE actually ended, mortgage rates rose briefly and then fell again. The Fed did nothing to push rates higher. Today mortgage rates are around 3.67 percent for 30-year, fixed-rate financing, not far off from the 3.31percent record low seen in 2012.
Second, for a very long time the Fed has expressly said that when unemployment dipped below 6.5 percent it would be time for higher interest rates. So — you guessed it — what happened in 2014 when the unemployment rate fell below 6.5 percent? Nothing. As the Fed explained with its own unique logic, “the existing forward guidance, with its reference to a 6.5 percent threshold for the unemployment rate, was becoming outdated as the unemployment rate continued its expected gradual decline.”
One reason the Fed is moving with great care, if it is moving at all, is the fear that increasing interest levels could slow the recovery or even bring it to a halt.
This fear stems from the Great Depression, an event that lasted an additional seven years because of government policies according to 2004 research done at UCLA.
“Why the Great Depression lasted so long has always been a great mystery, and because we never really knew the reason, we have always worried whether we would have another 10- to 15-year economic slump,” said Lee E. Ohanian, a co-author of the study and at the time of publication vice chair of UCLA’s Department of Economics. “We found that a relapse isn’t likely unless lawmakers gum up a recovery with ill-conceived stimulus policies.”
Translation: Raising rates too quickly could slow a recovery and even bring a return to harder times.
Looking at the global economy the Fed has very good reasons to be “cautious.”
First, negative interest rates are becoming common. The European Central Bank and central banks in Spain, Switzerland and Denmark now pay negative interest. This means if you lend them $100 they will repay something less. Not to be outdone, Japan also is offering negative interest rates. If the Fed raises rates then even more foreign capital will come to the U.S., holding down mortgage rates and many other forms of interest.
Second, Mexico is now offering 100-year bonds, denominated in Euros, paying 4.5 percent. That interest rate, of course, reflects the incredible risk associated with long-term securities and the fact that we don’t know what will happen next Tuesday much less what will happen decades from now.
If the U.S. market is competing for cash with countries pushing 100-year bonds then bales of cash will flow into our markets. Here’s why:
About 100 years ago Czar Nicholas II borrowed a lot of money, in large measure to pay for Russia’s involvement in World War I — and maybe a palace or two. While the czar had solid credit things didn’t work out so well for either lenders or the Russian leader: In 1918 Nicholas and his entire family were taken out and shot, bathed in acid, buried in a pit and then the pit was filled in with concrete and railroad ties. The burial site was only found in 1991.
And what about the bondholders? In turns out that the folks who replaced the czar didn’t feel much obligation to pay his debts. It was not until 2000 — 82 years later — that the Russian government agreed to pay French citizens $400 million to settle all claims, czarist bonds being popular in France for reasons no one can explain. The bonds, by some accounts, once had a face value of more than $135 billion when corrected for inflation. ($10,000 in 1918 had the buying power of $114,040 in 2000.)
What Happens If Rates Go Higher?
If the Fed raises U.S. interest rates it’s unclear what will happen because the Fed’s command of the marketplace is less than absolute.
The mortgage marketplace is now flooded with capital, that’s one reason we have rates below 4 percent. If still more capital flows into the U.S. because of Fed policies then any rate increase might not last long as armies of new investors fight for returns.
Alternatively, the Fed could do nothing and rates might soar anyway. As an example, much of the world’s oil production is located near or in the middle of war zones. While prices are low today there are no guarantees regarding the future. If energy prices rise higher costs could spread throughout the entire economy, forcing up prices and setting off a new round of inflation. For the Fed, and everyone else, the thought of such energy interruptions is a nightmare.
According to NAR, “if there were to be some rise in energy prices in the near future (after having fallen big time late last year), then the overall consumer prices could get uncomfortable and thereby nudge up interest rates.” (parenthesis theirs)
This is a polite way of saying that the housing market is frail and could be demolished by higher mortgage rates. That’s a problem of great consequence because housing represents a large portion of the overall economy.
Lastly, if the Fed raises rates too early in the recovery there’s the possibility that such a policy could be a disaster. Consider that in 2014 we had low rates yet existing home sales actually fell. Imagine what would happen with higher rates.
The real problem faced by the Fed is that for all of its promises regarding a return to higher rates the economy remains fundamentally weak and steeper interest costs would make it weaker. Despite economic models and political claims to the contrary, much of the country continues to be deeply mired in recession.
How do we know? According to Homes.com, 117 of 300 major metro areas have now achieved a “full price recovery;” that is, real estate values at the end of 2014 were as high as they ever were before the mortgage meltdown. Sounds great, but in fact only 39 percent of the metro areas have recovered — while 69 percent have not.
Here’s another measure: The Federal Housing Finance Agency (FHFA) says that in January home values nationwide had the same prices as they did in December 2005, meaning home prices have not budged in almost a decade.
The Fed knows this stuff, reason enough to delay an interest-rate hike for as long as possible.