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
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
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
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
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
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
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