Tuesday, May 27, 2008

Week of May 12, 2008--Interest vs Inflation?

This is really a Q&A item. Some of my readers have asked if interest rates are going lower? This is when we are in some kind of mini-recession, at least for homeowners and wage earners in many parts of the country. Doesn’t that mean less of a demand for loans as in 2001, which resulted in record low interest rates?

Well, yes. In fact, conventional, conforming interest rates packaged by Fannie Mae and Freddie Mac are near their record lows—only 0.5 to 0.75 percent above those lows—as we speak. But not jumbo rates, which is where almost all of the subprime grief is contained. That is because it is in those jumbo loan regions, such as California, where most of the defaults are occurring.

Mortgages are backed by bonds, hence the term ‘mortgage-backed’ securities. The bond market looks at several variables, including inflation, which has been rising of late along with gas and food prices. Another demand factor is that much of those low rates were due to foreigners’ excess supply of dollars being reinvested in the U.S. budget deficit.

But federal debt has ballooned—now $9 trillion, up from approx. $4 trillion in 2000. This means too many dollars are floating around the globe, which has caused the dollar’s value to decline by approximately one-third against other major currencies. So there has been a falloff in foreign demand for U.S. bonds and other securities, as foreigners seek investments in other currencies.

However I see a favorable outlook for even lower mortgage rates over time. Inflation should be moderating over the next 2 years, according to Federal Reserve Governor Janet Yellen. This is because wages are barely growing, and wages comprise two-thirds of a product’s cost. Also, the slower housing market will exert a “downward pressure” on economic activity and hence consumer demand through 2009, according to Yellen and other Fed Governors.

The stock market is another factor controlling interest rates, since bonds serve as a flight to quality when stock prices fall. For now, stocks are rallying in anticipation of a second-half-of-2008 recovery, thus keeping rates from dropping further. But a stock market recovery is questionable at best and will probably not boost rates this year. Hence stocks will probably not have much affect on interest rates.

Will the Fed continue to lower interest rates? Not when the Fed’s 2 percent funds’ rate is now zero when inflation is factored in. The core rate of retail (CPI) inflation is currently averaging 2.3 percent over the past year. Inflation would have to come down, in other words, for the Fed to lower rates any more.

The Fed and Alan Greenspan actually lowered the fed funds rate to 1 percent in 2003, which was below the inflation rate. This was the ‘real’ cause of the housing and credit bubbles, since money was in fact less than cheap then. It actually paid to borrow, since inflation shrank the ‘real’ loan amount faster than the interest rates of that time.

CONSUMER PRICE IDEX—The CPI for “All Urban Consumers” rose just 0.2 percent in April, and is up 3.9 percent in a year. The core rate is 2.3 percent in 12 months, so inflation seems to be moderating, mainly because energy prices didn’t rise at all in April. But food prices are still growing 5.1 percent in a year.

Why the 2009 date for a housing recovery? The jumbo loan market could take that long to work through its bad loan inventory. NAR chief economist Lawrence Yun pointed out that homeowners with subprime loans account for less than 10 percent of all homeowners. “Even so, subprime mortgages account for more than half of all foreclosures. Sharp price declines are principally in neighborhoods where subprime lending has been widely prevalent,” he said.

But the typical seller in the first quarter, who purchased their home six years ago, saw a sizable equity gain despite a price drop from a year ago. The median increase in value for sellers who purchased that home in the first quarter of 2002 is 23.8 percent, and the median home equity accumulation is $37,700, said Yun.

© Harlan Green 2008

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