Fed Treading on Thin Ice as US Housing Bubble Weakens

By Mark Weisbrot

This article was published in the following news outlets:

McClatchy-Tribune News Service - June 30, 2006
Duluth News-Tribune (MN) -July 1, 2006
Norman Transcript (OK) - July 1, 2006
Traverse City Record-Eagle (MI) - July 1, 2006
Portsmouth Sunday Herald (NH) - July 2, 2006
Augusta Chronicle (GA) - July 3, 2006
Charlotte Observer (NC) - July 3, 2006
Hartford Courant  - July 3, 2006
Centre Daily Times (PA) - July 7, 2006
Miami Herald - July 7, 2006
Newport Daily News (RI) - July 7, 2006
Palm Springs Desert Sun (CA) - July 8, 2006
Lexington Sunday Herald-Leader - July 9, 2006
Cape Cod Times - July 10, 2006
Columbus Dispatch - July 10, 2006
Mountain Mail (CO) - July 27, 2006
Humbolt Sun (NV) - August 2006
Worthington Daily Globe (MN) - August 2006
San Gabriel Valley Tribune (CA) - August 3, 2006
Pasadena Star-News (CA) - August 3, 2006
Whittier Daily News (CA) - August 3, 2006

Everyone recognizes that the U.S. economy is slowing, but the question is, how bad will it get? One disturbing sign is that the Federal Reserve is raising interest rates as the economy slows, and it is not clear when it will stop. This is not good because each rate hike is deliberately designed to slow the economy by causing both consumers and businesses to borrow and therefore buy less. The idea, as Fed economists see it, is that as overall spending is reduced, employers will hire fewer workers. As unemployment rises, employees are in a weaker bargaining position, and this leads to slower wage growth. Slower wage growth, the Fed hopes, will lower inflation.

Although it is no secret among economists, most Americans don’t know that the Fed fights inflation by increasing unemployment and thereby lowering wages. The public probably would find this unsettling. Inflation, as measured by the Consumer Price Index, has been running at 5.7 percent over the last three months, up from 4.2 percent over the previous year. But most of this is the result of higher energy prices and the fall of the U.S. dollar against other currencies, which raises the price of imports and therefore adds to inflation.

The Fed sees rising wages as the problem, because the people who run the Fed do not look at the economy from the point of view of wage and salary earners. They have a “bankers-eye view” of the economy, which sees even a relatively small increase in inflation as a dangerous thing because it erodes the value of bonds. And for them, the way to keep inflation in check -- no matter what its cause -- is to keep wages from rising.

Average wages, adjusted for inflation, are less than they were four years ago – which is unfair, to say the least, given the economic growth over this period.

But it’s about to get worse. Since the mid-90s the country has accumulated an enormous housing bubble, as house prices nationally have risen nearly 70 percent after adjusting for inflation. In some bubble areas, mostly the east and west coast, the real increase has been over 100 percent. Since house prices have historically increased at about the same rate as inflation, this means that more than $5 trillion of excess paper wealth – similar to the stock market bubble of the late 1990s – has been created. Just as bursting of the stock market bubble caused a recession in 2001, the collapse of the housing bubble will almost certainly do so.

There is evidence that this bubble is already beginning to burst: new home sales, existing home sales, and the median price of existing homes were all lower in the first quarter of this year as compared to peaks last year. Vacancy rates for new homes are rising.

House prices do not have to collapse at once in order to tip the economy into recession. Many Americans use their houses as an ATM machine, borrowing against the value of their homes. These home equity loans, including hundreds of billions of dollars “cashed out” when people refinanced their homes as mortgage rates hit record lows in recent years, are what has driven the U.S. economic recovery since 2001. Falling home prices leave less equity that homeowners can borrow against. The personal savings rate is at a record low for the post-World-War II era, hitting negative 1.6 percent in April.

Rising mortgage interest rates will finish off the housing bubble if oversupply and a psychological reversal of the speculative mania don’t do it first. This party is about over, most unfortunately for the majority of Americans who never got to join in the festivities.

Mark Weisbrot is Co-Director of the Center for Economic and Policy Research, in Washington, DC