No question, the housing sector is slowing down. But is it the result of the Federal Reserve’s tightening of the money supply? And if so, is that bad or good?
Nationwide, July’s sales of new homes were down more than 21 percent from a year earlier and the inventory of unsold new homes hit an all-time high.
Residential building permits are down nearly everywhere. So far this year in the 11-county Twin Cities metro area, permits are down 18 percent. Comparing this July with July 2005, they are down 37 percent.
Sales of existing homes are slowing as well, according to the National Association of Realtors and other sources. For the nation as a whole, sales are at a 2½-year low and the inventory of unsold homes is at a record high.
So sales and construction clearly are down. Some interest rates clearly are up. The Federal Reserve started to constrict growth of the money supply two years ago, forcing its short-term target rate up by 4.25 percentage points since then. The prime lending rate is up about the same amount. Even so, mortgage rates — especially for fixed-rate loans — haven’t climbed as much.
Yes, these rates were a percentage point or so lower a year ago. They currently are at the upper end of a narrow band in which they have hovered for four years. They remain very low by historic standards and in comparison to inflation.
Last week, rates on 30-year conventional loans averaged 6.48 percent. Data from the Federal Home Loan Mortgage Corp. show rates were never that low from 1971 through July 2002. Since then, except in two months, these rates have stayed in a band from 5.5 percent to 6.5 percent.
So clearly mortgage rates have not increased in direct proportion to Fed tightening. In June 2003, the Fed’s target for the Fed funds rate bottomed out at 1 percent. It stayed there for a full year then slowly ratcheted back up to 5.25 percent.
When that Fed increase started, 30-year mortgage rates were about 6.3 percent or some 5 percentage points above the Fed funds rate. Now, at 6.5 percent they are just 1.25 points higher than the Fed’s short-term target. It is hard to characterize this as a dramatic increase in rates.
During the growth years from 1993 through 1999, inflation averaged 2.4 percent per year. Rates for 30-year loans averaged 7.6 percent. Adjusted for inflation, mortgage rates were about 5 percent.
Over the past three years, inflation has averaged 3.4 percent while mortgage rates averaged about 6 percent. While mortgage rates are up from their trough, they have not risen as much as inflation. Adjusted for inflation and compared with historical averages, mortgage rates simply are not high.
So if mortgage rates are not all that high when compared with long-run averages and adjusted for inflation, what is going on in housing?
First, while 30-year and 15-year mortgages have risen about 1 point, short-term one-year and five-year adjustable rates have increased more. Moreover, there are anecdotal reports that some lenders are tightening their lending standards.
Second, consumers are increasingly pessimistic. Even though mortgage rates have not increased much, they see higher gas prices, a do-nothing Congress and international political turmoil. They are understandably concerned.
On Tuesday, the Conference Board announced that its index of consumer confidence had fallen sharply in August, much more than analysts had predicted. Pessimism about the economy makes households less willing to stick their necks out on a new home, even with stable mortgage rates.
The most important factor, however, is that real estate and construction were in an unsustainable boom. Many people were building and buying houses with the primary objective of selling them for a profit.
Such booms are self-propagating for a while but must eventually die out even if interest rates do not rise. Irrational exuberance is fun while it lasts. When it abates, there is a frenzied rush for the door and someone always gets trampled.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.