What Spooked the Fed, Part II

Photograph by Panoramic Images

The housing market: a ferocious bear, fattened on ultra-low interest rates.

Yesterday this blog speculated that the Fed decided to continue the quantitative easing program because despite a falling unemployment rate, number of people still locked out of the labor force showed the economy was still in a deep funk. Since then, some folks have pointed to long-term rates, arguing that the Fed’s was driven mainly by the increase in long-term interest rates.

The Economist‘s Buttonwood columnist, Philip Coggan, writes:

What seems to have spooked the Fed is the one percentage point rise in Treasury bond yields since the first hints of tapering. This has delivered monetary tightening which has had an impact on consumers via mortgage rates; refinancings are down 70 per cent over the last year.

No doubt that could a factor (yesterday’s entry considered mortgage rates, too). It doesn’t seem to be central because the Fed presumably always understood that when tapering ended, long term interest rates would rise. If that’s what you’re looking at, there will never be a good time to change the Fed’s policy; the title of the Economist article, “If Not Now, When?” says as much.

There is every reason to take Ben Bernanke at his word that the decisions on Fed policy would depend on the underlying economy. Or, as Business Insider’s Joe Weisenthal says:

Unemployment was underlined in the Fed’s statement yesterday. Note the part about keeping the federal funds rate near zero “at least as long as the unemployment rate remains above 6-1/2 percent.” That actually moves the goal posts from the 7 percent mark that everyone was watching, showing the Fed is becoming even more sensitive to the employment situation.

So what happens if or when we do get to 6.5 percent unemployment? On this the Economist has a point: wherever the unemployment stands, the economy, and especially housing, remains heavily dependent on the Fed’s rock-bottom rates. Expectations of Fed tightening have already sent mortgage rates surging (chart’s to the right), scaring everyone counting on a housing recovery.

The danger  is that we’re feeding exactly the same grizzly that dined so well in the mid-2000s. Last month, a fascinating paper from Fannie Mae economists predicted that residential investment would soon be back up to its “normal” share of the economy, based on historical averages going back to 1929. One difference between today and earlier decades, however, is that the U.S. population growth rate has fallen by half in the last 50 years.

The “normal” housing investment of the past was driven, at least in part, by faster population growth — ie. housing got built because there were more people to house. Now  the housing market, and the industries it supports, are propped up by ultra-low interest rates. And the higher housing goes, the scarier it is to stop feeding it and have the bear pounce again.

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