The Fed's Dilemma Continues
by Comstock Partners, Inc.
Thursday, August 25, 2005
On the eve of the annual financial symposium at Jackson Hole, hosted by the Kansas City Fed, that so-called “conundrum” mentioned a few months ago by Chairman Greenspan is with us once again. When the FOMC first began hiking the fed funds rate from 1% in June 2004 the 10-year bond rate stood at about 4.70%. About a year later, after eight straight 25 basis point increases to 3%, the 10-year rate had plunged to 3.89% by June 7, 2005. After two more increases in the funds rate to 3.5% on August 9, the 10-year rate had climbed back to 4.43%, but in just a little over two weeks has now dropped again to 4.17%. This has to be enormously frustrating for the Chairman, who is trying desperately to cool the increasingly dangerous housing bubble. The longer the 10-year rate refuses to go up the more the Fed has to raise the funds rate, and the more likely it is that the yield curve inverts and sinks the economy into recession.
That the Fed is trying to cool the housing bubble should at this point be obvious to all, although it is often denied by both Fed officials and outside economists. In mid-May the Fed and a number of other regulators issued a directive to mortgage-issuing institutions urging them to be more prudent in the kinds of loans they were issuing. In his testimony to the Senate and House, Greenspan spent about six of fourteen pages detailing his concern with the overall housing situation. Although he referred only to “froth” in “local” housing markets, it is clear to any thinking person that these local markets—the Northeast, Florida, West Coast, and numerous places in between--constitute a major portion of the population and of current home values. Indeed, Greenspan’s own use of the word “conundrum” obviously expresses his own frustration that the lengthy series of Fed tightening had not moved the long-term rate higher.
Although there is a great deal of debate about whether a housing bubble actually exists, it seems to us that those denying it are—well, in denial. Despite the soaring home prices, U.S. homeowners’ equity has dropped to 56% of their home value from 75% about 20 years ago. Cash-out refinancings are now 18% of all refinancing, up from only 7% two years ago. In the last four years owners have take some $560 billion in equity out of their homes, and a significant portion of this has been spent, enabling U.S. households to run their savings rate down to zero, and resulting in record household debt. About 47% of mortgages loans are now non-traditional, raising the prospect of a deluge of defaults in the next recession. In addition 23% of homes in 2004 were bought as investments and another 13% as vacation homes. Certainly, The Federal Reserve, Fannie Mae, Freddie Mac and the National Association of Realtors know what’s going on. After all, they developed the statistics we just cited.
Since 1999, when the financial bubble was in full bloom (due in large part to the Fed), we have been saying that the central bank faced a dilemma with limited choices—none of them good. They could either kill the bubble, let the economy and markets take the hit and come out of it ready to resume healthy growth—or they could keep extending the bubble for a while longer with far worse consequences down the road. The Fed, under Greenspan, chose the latter course, resulting in a dangerous housing bubble following the financial bubble of the late 1990s. This is evident in the fragile unbalanced recovery, the massive trade deficit, low consumer savings rate and record household debt. The standard measures of the economy indicate to many that Greenspan has won his bet, and the Jackson Hole symposium will probably be full of praise for his long tenure. We hope that they are right, but we believe that the final word on Greenspan’s reign as Fed Chairman is not yet written, and history may not view him kindly.
© 2005 Comstock Partners, Inc.
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