The Federal Open Market Committee meeting Tuesday is likely to be a difficult one. The political and economic pain from rising interest rates is beginning to bite, and it’s going to get worse. Meanwhile, there’s no sign of a decline in inflation, nor is there likely to be, as real interest rates remain near zero. The Fed’s in a corner, but it didn’t have to be.
The Fed raises interest rates to achieve certain policy objectives. Most important of these objectives is controlling inflation, but in this cycle, which itself has occurred because of excessive Fed laxness in the past, it’s also necessary to reduce the U.S. trade deficit, currently approximately $800 billion per annum and climbing, and restore the U.S. savings rate, which has dropped to minus 1.5% owing to excessively easy money that has made it trivially easy to borrow and left no incentives to save.
All these objectives take time to occur. Reducing inflation, now running at well over 4% per annum, requires “real” interest rates (net of the inflation rate) of at least 3-4%, thus nominal interest rates in the 8% range. There’s a very long way to go on the trade deficit, and we may have to endure a lengthy recession to get there –to get it back down to the $200-300 billion range we’re talking a shift of 5% of GDP, or an increase of more than 30% in U.S. exports. Changing the savings rate is largely a matter of behavior; the continuing strength of mortgage refinancing, down from the last few years but around the 1998-99 peak levels in a year that interest rates have increased significantly and house prices have stalled, indicates that the U.S. consumer will go on maxing out his credit cards until he’s forced not to.
On the other hand, the bad stuff happens pretty quickly. New single family home sales were down 11% in June from the previous year, while the homebuilders’ confidence index was down from a high of 72 to 39 in July over just 13 months and the Mortgage Bankers Association’s mortgage applications survey registered the weakest mortgage demand in four years. Although there’s a lot of fat in the homebuilding sector from the boom years of 2002-5, so real pain is some months away, there can’t be much doubt that by the end of this year there will be some serious squawking from the sector.
The trouble is rather more imminent in automobiles, whose sales were down by 17% in July from the inflated levels of the preceding year (caused by an “employee prices” promotion that severely dented margins.) With both GM and Ford wobbling near breakeven and losing market share for decades, there isn’t much fat to cut. Ominously, imported brand sales were up 4.3% in the first 7 months of 2006, while domestic brand sales were down 11.5%. Part of this was due to oil prices – domestic producers were strong in SUVs and minivans whose July sales were down 30% from the prior year. But oil prices aren’t likely to drop back soon, so the outlook for automobile profitability and employment must be grim. Indeed, the unemployment rate ticked up from 4.6% to 4.8% Friday, and job creation was weak.
Both houses and autos are mostly financed by loans, so purchases are heavily affected by interest rates. For example, General Motors Acceptance Corporation’s funding costs averaged 5.79% in the second quarter of 2006, up 1.19% from the prior year, so 0% financing deals have become more expensive to the manufacturer, and auto loan rates have increased.
In fighting inflation it’s the real interest rate that matters. Only by raising short term rates to a level at least 3-4 points above the current inflation rate can the Fed hope to have any effect. Conversely, in automobile or home financing the loan’s real rate of interest is less important than its monthly cash cost, which rises with nominal not real interest rates. The potential sale price of the automobile is irrelevant, and that of the house not much less so. If prices are rising by 5% per annum, but loan rates are 7%, the monthly payment is much higher than if loan rates are 4% and prices stable, even though in the inflationary case the real interest rate is lower (2% as against 4%).
Of course, over time the real value of the loan payments will lessen as the borrower’s income rises in cash terms, and in the case of housing (but not generally automobiles) if prices are rising along with general inflation, the borrower will make the money back when he sells the house. However, neither of these factors makes the monthly payments more affordable now, so demand for housing or automobiles is severely affected by rising nominal interest rates, even if real rates remain low.
This (in reverse) explains the housing boom of the last few years. Even though inflation was low, so real long term interest rates were not generally negative, nominal rates were far below their levels for any period since the early 1960s, so housing “affordability” was exceptionally high. This allowed house prices to be driven up to levels that were in real terms far above those of the last boom in the late 1980s, when both inflation and mortgage rates were higher.
If inflation had remained low, long term interest rates would also have remained low and house prices could have remained at their new elevated levels. However, inflation has taken off, if only so far to the 4-5% level, so nominal interest rates must rise to levels that give a positive real return, and the exceptional house price rises of the last half decade must thus reverse. Thus although the automobile sector has provided the first evidence of pain from the Fed’s interest rate rises, it is in the housing sector that their long term effect will be most bitterly felt.
The long series of ¼% rises over the past 26 months in the Federal Funds rate, from 1% to 5¼%, has so far had very little political or economic cost. The housing and automobile sectors have weathered the increases easily, largely because long term interest rates have risen much less than would have been expected from such a large rise in short term rates. However, this is about to change. The political and economic pain from further interest rate rises will be substantial, and will get considerably worse as the lagged effect of past rises on the housing and automobile markets kicks in.
Meanwhile, since real interest rates are still very low, less than 1% even if you believe the official inflation figures, the rate of inflation remains generally rising not falling. When nominal rates are raised enough to throttle inflation (a Federal Funds rate of about 8% at present, but higher if the rise is delayed and inflation gets worse in the meantime) the effect on the housing and automobile sectors will be correspondingly more vicious.
In other words, by raising rates so slowly, the Fed has managed to engineer a situation in which none of the benefits of higher rates have happened or are imminent, while the costs of higher rates are about to hit the U.S. economy and political system like a repossessed Mack truck. Alan Greenspan and Ben Bernanke, once again, a masterstroke!
Guys, this isn’t rocket science. Since the major benefits of higher interest rates happen slowly, and depend on the real rate of interest after inflation, while the costs of higher rates happen fairly quickly and depend on the nominal interest rate, it follows that if you’re worried about inflation you need to raise rates quickly, not slowly, to get to a teeth-clenching real rate of interest without allowing inflation to chase rates upwards.
If you’re sitting in June 2004, observing a consumer price index that in the 12 months to May 2004 rose by 3.0%, you know you will need to raise rates to a level at least 3% above the rate of inflation, to return real monetary policy to a neutral posture, and that there’s some chance you will need to raise rates somewhat higher than that. A Federal Funds rate of 6%, in other words, but done immediately.
If the Fed had raised the Federal Funds rate from 1% to 6% in one jump in June 2004, removing the excess accommodation it had introduced into the system since January 2001, inflation would have stopped increasing. Home mortgage rates and automobile loan rates would have risen, but to a level only modestly higher than today’s. Instead of the costs of higher interest rates appearing without any sign of their benefits, both would have appeared at once, a much more satisfactory position. Once inflation was firmly under control, interest rates could have been ratcheted downwards as inflation fell and economic recovery would have occurred.
House prices would have dropped, but from the lower price levels and lower debt levels of 2004, therefore producing a smaller, more manageable downturn, with fewer bankruptcies. Similarly, Detroit would have faced higher automobile financing costs with oil at $40 per barrel not $80.
Oh, and the stock market would have dropped too, albeit from its somewhat lower level of 2004. You say the stock market hasn’t dropped yet? Wait and watch, ladies and gentlemen, wait and watch. It should be quite a show!
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)