WILL FED RATE CUTS CONTINUE?

“The U.S. Federal Reserve and other major central banks moved in concert to slash key interest rates as part of an ongoing effort to quell financial turmoil that has threatened to flatten the international economy”, was the headline event last week.

Why such an unusual move, and will the rate cuts continue? "Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months," the Fed said in its statement. "Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

European banks were also worrying about their balance sheets. The Bank of England as well as EU, Swiss, Swedish, and Canadian Central Banks also cut their rates one-half percent. Rates were cut simultaneously to protect their currencies, since individual countries cannot lower interest rates without devaluing their currencies internationally.

The U.S. Fed lowered their overnight rate to 1.5 percent to stimulate consumer spending for the holiday season. One reason for the Fed’s action was that consumer credit had shrunk in August for the first time since January 1998, while retailers have been making gloomy predictions for the rest of the year.

What this might do for housing is still in question. But the Pending Home Sales Index, a forward-looking indicator based on contracts signed in August, rose 7.4 percent to 93.4 from an upwardly revised reading of 87.0 in July. The index is now at the highest level since June 2007, which might augur an improvement in existing-home sales.

Lawrence Yun, NAR chief economist, said home buyers were responding to improved affordability. “What we’re seeing is the momentum of people taking advantage of low home prices, with pending home sales up strongly in California, Nevada, Arizona, Florida, Rhode Island and the Washington, D.C., region,” he said. "It’s unclear how much contract activity may be impacted by the credit disruptions on Wall Street, but we’re hopeful most of the increase will translate into closed existing-home sales.”

Builders are also beginning to build smaller homes in order to increase affordability, for the first time in this writer’s memory. Los Angeles-based KB Homes had shrunk its homes from 3,400 square feet, selling for $450,000, to 2,400 square feet selling for $300,000 to appeal to buyers. Now, it's shrinking its homes yet again--1,230 square feet priced at about $200,000.

Other builders, including Warmington Homes and John Laing Homes, have taken similar approaches. “We're getting back to more the way things were historically, kind of undoing the excesses, not just from a price perspective but home size and (fewer amenities)," says Nishu Sood, a Deutsche Bank analyst.

The new KB Homes aren’t just smaller, they are more efficiently designed, says Steve Ruffner, president of KB Home's Southern California Coastal Division. "You could have a three-bedroom, 2,500 square-foot single-story home and all you had was wide hallways and bigger rooms. It wasn't really giving [buyers] the utility," Ruffner says.

The Federal Reserve has to print more money for as long as it takes to get banks lending again. Though the unemployment rate remained at 6.1 percent in September, jobs were lost in all sectors of the economy. That means extending unemployment insurance benefits for at least another 13 weeks.

U. S. and European governments are in effect nationalizing their banking systems to keep them solvent. We are seeing a return to Roosevelt’s New Deal. This also means we taxpayers will now have an ownership share in the banks that have been rescued, in order to guarantee repayment of those $ billions in government loans.

© Harlan Green 2008