- The Washington Times - Tuesday, August 16, 2005

Last week the Federal Reserve again raised the federal funds interest rate, which now stands at 3 percent. When the Fed began tightening monetary policy in June 2004, this rate was just 1 percent.

There is little evidence the Fed’s actions have affected either financial markets or the real economy. Market interest rates, especially for mortgages, remain low. Economic growth continues steadily if unspectacularly. Given the Fed’s actions, economists would have expected higher interest rates and slower growth. The Fed calls the lack of effect a “conundrum.”

As a result, some analysts say 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 the rate to hit 4 percent before the Fed stops. Economists at Goldman Sachs predict 5 percent.

But the Fed raising rates gradually doesn’t mean the effect will be gradual. It could come quite abruptly. Think of a balloon. Whether you inflate it up slowly or quickly, at some point it will burst. The same is often true of monetary policy. It may appear nothing is happening for a long time, then some dramatic, sudden event shows monetary policy working as expected.

Another problem is that the Fed’s policies always take time before they have an effect. And these lags vary. So it’s very difficult to know precisely when the effect will be felt.

Generally, when the Fed tightens, the effect on the economy is symmetrical. That is, whatever sectors rose the most in 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 effect has been on housing. In the last five years, housing prices nationally have risen by more than 50 percent.

In some areas, prices have risen much more. California and the District of Columbia are up more than 100 percent. Twelve other states have seen increases of more than 60 percent. All but 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 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 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 prices will either level off or fall when this happens, bringing the ratio back to trend.

One thing that may be different this time is the abnormal price-to-rent ratio is driven partly 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 bought 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 lenders. 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 when the property is sold. So unless prices rise fairly rapidly, one can easily find the mortgage is greater than what one can clear at closing. Consequently, even if prices simply level off, many investors may find themselves with mortgages they cannot pay back after a sale.

Owning one’s home is still the best possible investment. 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 much longer than they expect to make money. They should be capitalized well enough to ride out a market dip.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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