Last week the Federal Reserve again raised the federal funds interest rate, which now stands at 3.5 percent. When the Fed began tightening monetary policy in June 2004, this rate stood at just 1 percent.
Thus far, there is little evidence that the Fed's actions have had any effect either on financial markets or the real economy. Market interest rates, especially for mortgages, remain low, and economic growth continues at a steady, if unspectacular, pace. Given the Fed's actions, economists would have expected interest rates to be higher and growth to be slower. The Fed calls the lack of impact a "conundrum."
As a consequence, some analysts are saying that the Fed will have to raise the fed funds rate higher than it originally planned. A majority of forecasters in the Wall Street Journal's latest survey expect it to hit 4.5 percent before the Fed stops. Economists at Goldman Sachs are predicting five percent.
The problem is that just because the Fed is raising rates gradually doesn't mean that the impact will be gradual. It could come quite abruptly. Think of a balloon. Whether you blow it up slowly or fast, at some point, it is still going to burst. The same thing oftentimes occurs with monetary policy. It may appear that nothing is going on for a long time and then, suddenly, something dramatic happens to show that monetary policy is working as expected.
Another problem is that the Fed's policies always take time before they impact, and these lags vary. So it's very difficult to know precisely when the impact will be felt.
Generally speaking, when the Fed tightens, the impact on the economy is symmetrical. That is, whatever sectors went up the most during the easing phase will fall the hardest when it tightens. Stocks went up most during the easing cycle from 1995 to 1998 and fell the most after the Fed tightened in 1999 and 2000.
In the latest easing phase, which began in January 2001, the principal impact has been on housing. Over the last five years, housing prices nationally have risen by just over 50 percent. But in some areas, prices have risen much more. Those in California and the District of Columbia are up over 100 percent. Twelve other states have seen increases of over 60 percent. All except Nevada border either the Atlantic or Pacific oceans.
However, much of the country has not seen significant housing price increases -- in 32 states they have risen less than the national average. In Utah, prices have gone up just 17.5 percent in the last five years -- little more than the 12.8 percent increase in the Consumer Price Index. Other laggards include Indiana (19.8 percent), Mississippi and Nebraska (both 21.8 percent). Almost all of the below average states are in the nation's heartland.
In a recent speech, Federal Reserve Bank of San Francisco president Janet Yellen noted that the ratio of home prices to rents is about 25 percent above its long-term average. In Los Angeles and San Francisco, the ratio is 40 percent above normal. Experience shows that prices will either level off or fall when this is the case, bringing the ratio back to trend.
One thing that may be different this time is that the abnormal price-to-rent ratio is being driven partially by falling rents, not just rising home prices. This is because investors are purchasing so many properties in hopes of rapid appreciation, increasing the supply of rental housing. And since much of this real estate has been purchased with interest-only or negative-amortization loans, investors don't need much rent to cover their payments.
Negative-amortization loans are especially dangerous, both for borrowers and those making such loans. This type of loan is a bit like a credit card, where the full amount need not be paid every month. As long as a small minimum payment is made, the balance can be rolled over. In this case, the unpaid balance is added to the outstanding mortgage.
This reduces one's cash flow expense, but also reduces one's profit at the back end when the property is sold. So unless prices rise fairly rapidly, one can easily get into a situation where the mortgage is greater than what one can clear at closing. Consequently, even if prices simply level off, a lot of investors may find themselves with mortgages they cannot pay back after a sale.
Owning one's own home is still the best investment that anyone can make. And if you plan to stay put for a few years, you shouldn't worry about a bust in the housing market. But those buying investment properties on either coast should be very, very careful. It may take a lot longer than they think to make money and they should be sufficiently well capitalized to ride out a market dip.