South-Western EconNews

South-Western College Publishing - Economics

The Housing Bubble and the Fed

Subject

Housing and Interest Rates

Topic

Monetary Policy

Key Words

Interest Rates and Housing Bubble

News Story

Many forecasters are confounded by the continued growth in the U.S. housing market. Despite expectations of decline, new home sales shot up at 12.2 percent in March to a record annual pace of 1.43 million units. This growth comes despite slightly higher mortgage rates last month and some analysts see this anomaly and predict a housing bubble that may soon burst.

Some analysts predict slower housing market growth is just ahead, and higher interest rates could slow the economy down. “Looking ahead, consumers do not anticipate an improvement in economic growth, nor in their incomes,” reported Lynn Franco, director of the Conference Board’s Consumer Research Center. Franco also reported that many people expect it to be harder to find a job over the summer months.

Nevertheless, Fed officials have given little credence to any data suggesting an economic slowdown. They remain focused on not allowing inflation to get a foothold in the economy and they intend to continue their self-prescribed gradual pace of increasing short-term rates.

This “hot” market has caused housing prices to increase by as much as 20 percent in parts of California, Florida, and along the East Coast. Despite rising prices, however, housing sales continue at a record pace. “It still appears that it doesn’t take much to generate faster home sales,” said Bank of America’s senior economist Peter E. Kretzmer. In fact, Mr. Kretzmer suggested that the housing market might actually gain strength because long-term interest rates have actually edged down a bit since March.

Fed chairman Alan Greenspan told House lawmakers in February that this phenomenon of continued low level long-term rates was a “conundrum” that he could not fully explain. If they continue, the housing bubble will likely expand.

“Low interest rates, in turn, have been a major force driving the phenomenal run-up in residential real estate prices over the past few years,” said Fed governor Donald L. Kohn. He discounted worries about a crash in real estate prices, but did indicate that prices had climbed high enough to “raise questions” about increases in speculative buying and overvaluation.

“We think there is a bubble, and we think the risks are higher that it will burst,” said Sheryl King, a senior economist at Merrill Lynch. “Even if you adjust for population growth, you’re seeing numbers that are bigger than any we have seen at this point in any previous economic cycle.”

For now, this escalation in home buying is one more reason for the Federal Reserve to continue upward pressure on interest rates. The central bank is expected to raise short-term rates by another quarter point at their next meeting. If this increase occurs, it will bring the federal funds rate to 3 percent, which would be the eighth rate increase since last June.

Questions

1.	Discuss how long-term interest rates impact home sales.
2.	Use your text to answer this question: “Is spending on new housing considered to be consumption or investment?
3.	Discuss how “speculative buying” and “overvaluation” relate to the bubble bursting.

Source

Edmund Andrews, “Consumers Are Wary, but Housing Remains Hot”, The New York Times Online, April 27, 2005.