The Housing Boom Will End

By Duru

August 30, 2005


I did not take Hurricane Katrina seriously after both my southeastern-dwelling brothers dismissed its impact.  Sure enough, the storm whizzed right by them, but now, hundreds of thousands of people in Mississippi and Louisiana are wishing they never met the thing.  Similarly, when Greenspan made his annual comments at Jackson Hole, Wyoming, I yawned.  I expected more econo-babble that reiterated more of the same that we always hear from good ol' Greenie.  Now, as scores of headlines continue to pour in announcing that Greenspan made his most stern warnings yet about America's finances, I suddenly began paying much closer attention.  The last time I felt Greenspan got really serious was when he warned that the world will not continue to finance American's profligate spending habits for much longer.  I noted that Greenspan and the Fed got decidedly more hawkish about raising interest rates during the March, 22, 2005 meeting.  I temporarily got distracted by the Fed's claim that long-term prospects for inflation are "well-contained."  I think the rest of the market was thrown off the scent as well given that a multi-month rally ensued.  I can only presume part of the rally was about anticipating an imminent end to the Fed's rate-hike campaign.  Lastly, I threw my hands up in frustration as Greenspan seemed to imply that any slowdown in the housing market would "only" hurt those who came late to the party.  My frustration was amplified because Greenspan made this warning at the same time he seemed to dilute the notion of a housing bubble by dispersing the phenomenon as localized events.

But now, and finally, Greenspan has spoken loud and clear and in no uncertain terms that he is going after the boom in housing.  It seems that the psycho-babble back in late May set the stage for this big hammer.  While the main speech makes for good reading, I paste here the comments he made in closing out the confab in Jackson Hole because Greenspan makes his claims clearer than ever - (you can even detect some hints of plain English!):

"Nearer term, the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely.

The surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports, and a corresponding improvement in the current account deficit. Whether those adjustments are wrenching will depend, as I suggested yesterday, on the degree of economic flexibility that we and our trading partners maintain, and I hope enhance, in the years ahead."

The emphasis is mine…. when did Greenspan ever admit that housing prices could actually go down in such plain talk?!  This claim violates the very tenet underlying the current bubble in housing - that housing prices never decline in the United States.  Greenspan did not even condition this statement by saying that housing prices may decline in certain overheated markets.  We can now plainly see that Greenspan is looking forward to a day when the housing bubble has been broken because he has already thought through and anticipated the larger financial consequences.  In fact, we know that Greenspan has grown increasingly alarmed at the rapid growth in government deficits - both the trade and budget deficits - so we can conclude that he welcomes the prospect of a broken housing bubble dragging down these twin towers of debt with it.  Greenspan is probably also crossing his fingers that he does not kill the entire economy in the process; in fact, he seems to be relying on cooperation from other players in the larger global economy to help out here.

Folks, even I cannot say it plainer than Greenspan now:  the housing boom will end.  And given the Fed is now actively targeting the demise of this boom, this party will end sooner than we can imagine right now.  Long-term rates remain the wildcard piece of the puzzle.  As long as they stay low, it will still make sense for a lot of folks to continue buying up real estate for all types of reasons and purposes.  The subsequent pain of the most speculative of activity in real estate will depend on just how fast these rates rise after they finally decide to pay attention to the Fed's aggression.  The yield curve is almost flat right now, and it seems the Fed will now continue charging ahead even if they force an inversion of the yield curve.  The ultimate irony of such an event would be an economic recession that brings all rates right back down…and then the housing boom might be broken because incomes contract too much to maintain all the debt that the post-bubble economy has accumulated.

We have a dangerous game of chicken going on, and you and I may be the ultimate losers.

As a final note, for those folks who were surprised to hear Greenspan "admit" that the Fed now considers asset prices in determining Federal Reserve policy, you need not look far to find the Fed already admitting to such activity.  For example, Governor Gramlich made a speech in France in 2001 where he tried to clarify the Fed's approach to stock prices:

"Now let me turn to the influence of these movements in asset prices on the conduct of monetary policy. The fundamental goal of our policy is to achieve maximum sustainable output and employment, which can be reached best in an environment of price stability. Therefore, the Federal Reserve must take an active interest in all the factors that affect economic performance, including business and consumer confidence, economic growth abroad, the foreign exchange value of the dollar, fiscal policy, and, of course, asset prices. We take the level of the stock market into account when we consider the economic outlook and monetary policy. But let me be clear: We do not target a particular level of equity prices. We attempt simply to judge the likely influence of the stock market as well as other important factors on the level of aggregate demand and aggregate supply and, hence, on the economy’s ability to achieve price stability and maximum sustainable employment. In this respect, the stock market plays the same role in our analysis as does any other influence on our outlook. While our goal of price stability can foster a favorable environment for business investment, we make no pretense to being able to control how that plays out in the stock market. We cannot avoid gauging the effect of the stock market on economic performance, but we do not target stock prices."

Next, Governor Bernake made it clear in a lecture in Pennsylvania in 2003 that the Fed has spent considerable time researching the interplay of monetary policy and stock prices.  The implication here is that if monetary policy can encourage asset inflation, it can also cause asset deflation by acting in reverse:

"It is true, as I have discussed, that an easier monetary policy raises stock prices, whereas a tighter policy lowers them. However, easier monetary policy not only raises stock prices; as we have seen, it also lowers risk premiums, presumably reflecting both a reduction in economic and financial volatility and an increase in the capacity of financial investors to bear risk. Thus, our results suggest that easier monetary policy not only allows consumers to enjoy a capital gain in their stock portfolios today, but it also reduces the effective amount of economic and financial risk they must face. This reduction in risk may cause consumers to trim their precautionary saving, that is, to reduce the amount of income that they put aside to protect themselves against unforeseen contingencies. Reduced precautionary saving in turn implies more spending by households. Thus, the reduction in risk associated with an easing of monetary policy and the resulting reduction in precautionary saving may amplify the short-run impact of policy operating through the traditional channel based on increased asset values. Likewise, reduced risk and volatility may provide an extra kick to capital expenditure in the short run, as firms are more likely to undertake investments in new structures or equipment in a more stable macroeconomic environment."

Certainly, Greenspan has often implied that the Fed could not care less about stock and asset prices when he was questioned about this topic.  The astute watcher could see between the lines and understand the real story.  The two quotes above provide additional points of proof that the Fed has always cared about asset price levels.  Until now, the Fed never seemed to do much about these asset prices.  This time, they seem to mean business.  Be careful out there!


© DrDuru, 2005