Monday, August 9, 2010
I haven't featured this chart in over a month, and meanwhile 30-yr fixed rate mortgages have been hitting new all-time lows (both conforming and fixed!). This is a big story that deserves attention.
As some readers have reminded me at various times, Milton Friedman once observed that low interest rates are an excellent indicator that inflation is low, so they wonder why I keep predicting that inflation will rise. My response has been that while low inflation does indeed lead to low interest rates, and vice versa, the two don't necessarily move in lock step. Often it takes a period of high interest rates (the result of Fed tightening) before inflation moves down and interest rates eventually follow. The early 1980s would be a great example of this. Similarly, it often takes a period of low interest rates (the result of Fed ease) before inflation pressures rise and interest rates eventually follow. The 1970s were a good example of how low interest rates can lead to higher inflation and higher rates. I think we've been in the latter kind of period for some time now. Remember, Milton also observed that the lags between monetary policy can be long and variable.
My sense is that the market looks at today's rates that are very low and falling, adds in Milton's observation about low rates and low inflation, and infers that inflation may actually be at risk of being so low as to threaten deflation. I think there's a decent chance the market may not be reading things correctly, and may be failing to learn the lessons of the past.
In any event, it is also the case that low interest rates can be a sign of a chronically weak economy, such as Japan has suffered for decades. When investment opportunities are scarce, it doesn't take much of an interest rate incentive to balance savings flows with investment demands for cash. This could be the reason for why mortgage rates are so low and why so many continue to worry housing prices have not yet hit bottom: low mortgage rates could be signaling that there is a shortage of mortgage borrowers relative to the number of investors willing to buy MBS—thus, the demand for housing could fail to absorb all the housing supply that is due to hit the market over the next year or so as foreclosures allegedly pick up.
One needs to keep in mind, however, that there is as yet no indication that the housing market is not clearing or will soon fail to clear. (By clearing I mean that sellers are able to find buyers at some price.) According to the NAR, the monthly supply of unsold homes in the U.S. has fallen from a recession high of just over 11 months to now just under 9 months. Sales volume is up in many markets, particularly in California and Florida, and the Case-Shiller index of home prices in 20 major markets shows that prices have been flat to slightly up since early last year.
The housing market is clearing, and has been clearing for over a year. Between declining mortgage rates and declining housing prices and a recovering economy, the market has found a price that equates buyers and sellers. The ongoing decline in mortgage rates is obviating the need for lower home prices. Think of it this way: the bond market, thanks to its conviction that the economy is going to be very weak for the foreseeable future, has been acting as a great shock absorber for the housing market by bringing mortgage rates down to all-time historic lows. In this view, low mortgage rates could be signaling simply that the market is very pessimistic about the economy, not that there is a shortage of homebuyers. Higher rates wouldn't jeopardize the economy or the housing market, since they would signal rising confidence, stronger growth expectations, and the prospect of rising incomes and rising home prices. Higher rates would also be a sign of rising inflation expectations, and that would only add fuel to housing demand.
So I don't see any reason to think that the recovery is fragile or that the housing market is on the verge of another collapse. Instead, I see lots of signs that investors are very concerned about the future of the economy, and I find little or no evidence in my list of key indicators for a reason to share those concerns.
Posted by Scott Grannis at 2:15 PM