The era of high interest rates is over?
September 16, 2007
– Comments (3)
This coming Tuesday the Fed is meeting to lower interest rates. It is debatable whether this will be a 0.25% cut or 0.5% cut, but it's all but certain that the current 5.25% rate won't hold.
Currently, all the market cares about is the 0.25% vs. 0.5% debate. But the more important question is whether we'll ever see a 5.25% interest rate again. I think it's exceedingly likely that we never will.
Our housing market has reached the stage where there is no going back. A $1 mln house can't hold its value unless the interest rates are low. And it can't appreciate further unless the interest reates are very low. And making houses appreciate 10% a year is the cornerstone of our economic policy. This is what America is all about.
There is no way the government can allow prices to drop. A zero percent growth for one year has already presented very serious problems, and a very modest 1.5% drop would have ruined the whole financial system if the Fed had not rushed to rescue the banks with liquidity injections. The system simply cannot allow any further declines. A 10% drop in housing prices is all it would take to make banks go belly up. And an increase of mortgage rates from 6% to 6.6% is all it would take to cause this 10% drop. In other words, the Fed's choices today resemble a 1-directional diode: they can lower the rates, but once lowered, they can't take that cut away.
As housing resumes its growth, which I expect it will, the Fed's choice will only get more limited. Ten years ago, taking the rates back to 8% was still feasible. Four years ago, housing prices would still allow to go back to 7%. Three years ago, prices were already at the level where 6% was the maximum rate that would not ruin the system. And two years ago, when the prices peaked, 5.25% became the maximum rate that could be sustained, and even that - only as long as the Chinese were buying our mortgage paper, creating the "inverted yield curve" paradox. Now, as the Fed is facing the problem of engineering the next stage of the housing rally, it has no options but to take the rates below 5%, and forever.
The bottom line is that today's US economy is like a world champion who is addicted to doping and if he wants to hold on to his title and his medals, the only thing he can do is increase the dosage. This is why as we're preparing to say goodbye to the 5.25% interest rates, we may as well wonder if it's a goodbye or a farewell.
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