Special Report: Now, the real concern is how will interest rates rise?

Economist Elliot Eisenberg’s Special Report for the Tucson Association of REALTORS Septemeber issue.

Once the Federal Reserve stops “tapering” on Oct. 29, the big question facing REALTORS®, lenders, and the business community is when will interest rates increase? For the Fed, the bigger question is how to raise rates?

Come November, the Fed’s experimental, amazingly loose monetary policy will reach uncharted waters.

Without drilling too deep, let me explain how we got here, why you should care, and what economic signs the Tucson Association of REALTORS® should be watching.

Amid the 2008 financial crisis, the Fed began to buy bonds to stimulate the economy and dodge a deeper recession. The economy was in tatters. Unemploy-ment was soaring. Near panic, the Fed took extreme action to buy $45 billion of Treasuries and $40 billion of Mortgage-Backed Securities… per month.

The $85 billion bond-buying binge, called Quantitative Easing (QE), bloated the Fed’s holdings from $800 billion to almost $4.5 trillion.

By Jan. 2014, the economy had healed enough for the Fed to taper (reduce) its stimulus by about $10 billion per month. QE’s cash infusion pushed interest rates way down and boosted Wall Street.

The end of QE is positive
On Oct. 29 when the Fed makes its last bond buy ($15 billion), think of a race boat driver taking his foot off the accelerator. It’s not peddle to the metal any more. Rather, it’s drift free for a while and see what happens.

The end of QE is very positive, a sign that the Fed has more confidence in an improving economy. Yet the concern is for the hazards and unexpected pitfalls to come. Deliberately pulling trillions of dollars from the economy has never been done before.

The Federal Reserve Board is smart and knows the process has high risk: it could take a decade to return to a normal monetary policy and healthy economy.

How? Raise the “value” of money
Traditionally, the Fed would just raise interest rates but that won’t work now. There are many complex, global factors in play. Too much money is available (supply ~ demand). Banks have excess cash reserves,the most in history.

So when the Fed does raise its rate from .25% to .5%, it will have no meaningful impact. Everyone expects it. That means the Fed will try several non-traditional tools to raise rates.

To urge banks to lend (reduce their reserves), “interest rate creep” will enable banks to earn a premium on their loans. Reverse repos are another unconventional tool. Basically, the Fed and banks trade bonds for cash in order to remove money from the economy.

At the same time, as the Fed receives interest payments on its bond holdings, it will stop reinvesting that income in more securities. Literally, the Fed will throw away that money for the good of the economy.

Regarding concerns about high inflation, that won’t happen any time soon. There is no evidence since the job market is still mediocre; GDP growth is sluggish.

Inflation pressures may build as the “value” of money increases. The signals to watch for include higher productivity and job growth. Watch for shortages of raw materials and other resources. And when labor gets tight, look for wages to go up.

Significant wage increases. That is the most important factor to watch. It tells the Fed that the economy is hopping, inflation is building and it’s time to seriously raise rates.

How high? How fast?
Forecasts by we economists vary widely. I expect quarter-point increases to begin in June 2015. By year- end 2015, the Fed Funds rate is likely to be about 1%. Basically, this is the rate that banks lend to each other.

How would this affect Tucson real estate? In the short run, it won’t.

Every step of the way, the Fed has stated what they plan to do and when they plan to do it. They said once QE ends, interest rates will rise. So relax, there will be no big surprises.

At year-end 2015, TAR and lenders can expect higher mortgage rates, likely three-quarters of a point more. Then, add another three-quarters of a point by year-end 2016. These higher mortgage rates won’t kill housing because again, everyone will know what’s coming.

Timing. That’s the biggest fear.
Remember: the Fed’s goal is a normal economy that grows along with higher interest rates. As GDP grows, more people will have jobs. Once wage growth kicks in, that juices the (qualifying) income of home buyers.

If the Fed raises rates too soon, before the labor market is fully recovered, the economy falls back into a recession. Yet higher interest rates are needed to keep the economy from over-heating, to avoid crazy inflation.

If the unemployment rate drops too far too fast, inflation will accelerate. If the Fed waits too long to raise rates, that delay will create an inflation bubble.

Inflation-recession. Recession-inflation. Back and forth. The risk is that the Fed might blow it and we’ll end up with higher interest rates and higher inflation.

Remember the potential hazards: the Fed is in deep, uncharted waters.

Super-low interest and mortgage rates are not the goals; both were results of the nation’s dire economic woes. At day’s end, the Federal Reserve’s desired outcome is returning to a strong national economy ASAP.

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  1. Sonny Ross says:

    We need to keep the U.S.economy moving even if it is slow growth so that we make more jobs available. In addition, we need the hourly wage to continue to increase.

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