Friday, July 06, 2007

Why the Federal Reserve Can't Bail Out the Real Estate Bubble

The real estate bubble was mainly a result of record low interest rates followed by a complete relaxing (forgetting?) of sensible lending standards.

Basically, the entire real estate bubble was dependent on lowering interest rates.

Without lowering interest rates, properties no longer rose in price. Once prices began to fall, banks closed the spigot of lending money.

So, if you want to know the direction of the real estate market, then look at interest rate trends.

Which way are interest rates headed? Clear signs point to higher rates.

And here is the reason: INFLATION.

Inflation is the number one concern of the Federal Reserve. Why? Inflation robs everyone of the value and purchasing power of money. Think of it this way - you may think you have a good amount of money in the bank. For example, maybe you have enough to buy a new car. But if inflation increases, your money will buy you less as the price of cars rise. So it is the Federal Reserves job to keep inflation in check - otherwise the wealth of our nation and population rapidly deteriorates. The primary tool the Fed has in its limited tool belt is controlling short term interest rates - the rate charged to banks to borrow money. To slow inflation, the Fed raises interest rates thereby causing the economy to slow down. This relieves demand and causes prices to come down.

So where does inflation come from? It comes from too much demand. With too much demand, you have inflation since too many people/organizations are competing for a limited supply.
Think of it this way. Every product you see - cars, televisions, clothes, appliances - have 3 major input costs: labor, energy, and raw materials. (there are other input costs, like machinery & facilities, but they usually don't fluctuate in price once established).

Today, all three major input costs: labor, energy, and raw materials, are all rising - some at near record levels. And historically, the Fed knows that once these inputs move higher, they get more and more difficult to control.

Here is how the inflation-making components currently look:
  • Labor: Unemployment is near record lows causing wage costs to rise. Wages are a huge cost for all goods, and when they rise too quickly everyone suffers as inflation removes the purchasing power of money.

  • Energy: Oil is currently trading above $72 a barrel - a number previously thought devestating for the economy. If prices rise much higher, the markets may panic as they digest this impact.

  • Raw materials: Commodities continue to climb in price as world demand increases. And with China and other economies rapidly growing, this trend will likely continue.
    With all three major input costs rising and at record highs, inflation should continue to be the primary focus of the Fed.

The next move by the Fed is likely to be up. With the current backdrop of economic numbers, there is little choice for them.

And with higher rates, there will be no relief for the declining of real estate.

So for those looking for the real estate market to turn around, you have a long wait, especially with the massive glut of properites on the market.

Like this post? Let us know:


Anonymous said...

Thats funny. KW realtors just had one of their most succ months selling properties in several years. Interest rates are not the only factors in property buying decisions. The BOTTOM Line is still PRICE and once prices go down far enough properties will sell. They are not making any more land and tough bldg restrictions will keep supplies down.

Anonymous said...

Inflation mainly comes from increased monetary supply, i.e. the government printing more money (actually they don't print it.)

Anonymous said...

The FED doesn't fight inflation. The FED CAUSES inflation!

The best they can hope for is to slow the process through creating/destorying credit and manipulating the interest rates.

The dollar has lost over 90% of it's purchasing power since the FED was established.

Cayo Dave said...

Prices of Key West real estate are dropping. Of course there will be homebuyers in the market - but it the elimination of the speculators that is causing supply to eclipse demand since the housing market overbuilt while the speculators were there. What is actually "funny" is that it is the realtors that think the real estate market is in better shape. In reality, it may only be better for them, since they earn fees for transactions. To every other participant (homeowners and sellers), the market is terrible.
Anonymous comment #2 - you are somewhat right: Inflation can be created by controlling the money supply, which the Fed does. But market based inflation comes from excessive demand for the amount of goods & commodities available.

Anonymous said...

I agree with the other poster, inflation isn't caused by "too much demand" and, indeed, the FED can solve the housing bubble by "printing more money." That way, debt can be paid off more easily since "people have more money" but "each dollar is worth less."

as an example, if the FED doubles the money supply, then you need to double your price or the FED just pushed your price down.

what the FED can't fix is the income versus housing cost problem.

Michael said...

Anonymous, give me a break! They do make more land! The amount of land only has meaning for humans in that if you have a fixed amount of land for a given number of people as in there is 100 acres of land for 10 people in an area then there is 10 acres per person. If an area suffers an outflow of population (upstate NY, CN, MA, etc., etc.) then one in effect makes more land. Check out the prices over the last 40 years in the above mentioned areas (I could name many others). Realtors are like stock brokers and the drive by media..."all the news that fits my views"!

Cayo Dave said...

Some random comments on some of the random comments:

Inflation mainly comes from increased monetary supply, i.e. the government printing more money (actually they don't print it.)

Yes, inflation can come from printing more money - and historically, that was typical cause of inflation - governments would simply print more and more money which devalued money and led to higher prices.
Today the Fed still controls the money supply, and it was the primary focus of Wall Street analysts from the 1950's through the 1980's.
More modern Fed thinking has begun to better understand the relationship of interest rates and inflation and has more wisely used the inflation-adjustment tool.

The FED doesn't fight inflation. The FED CAUSES inflation!
Erm, no - not at all.

I agree with the other poster, inflation isn't caused by "too much demand" and, indeed, the FED can solve the housing bubble by "printing more money." That way, debt can be paid off more easily since "people have more money" but "each dollar is worth less."
Inflation is caused by too much demand. Or you can look at it this way: Inflation is caused by too little supply. Inflation is (pardon the Wikipedia definition): "persistent rise in the general price level, as measured against a standard level of purchasing power."
Rising prices is caused by either your dollars becoming less valuable or by prices/commodities rising at the market.
If the Fed printed more money, it would be an inflationiary move, not disinflationary.
It all comes back to supply and demand. Too much supply, prices fall. Too much demand, and prices rise. This is the basis of inflation and the paradigm the Fed works within.

Anonymous said...

You are a f***ing idiot.

Inflation is an increase in the money supply. That's all there is to it. See Ludwig von Mises and Austrian economics. You must be a real estate agent or a fool.

The federal reserve increases the money supply through various tools, including short-term interest rates and repurchase agreements (Repos).

The Federal Reserve doesn't ensure price stability or for rapidly disappearing middle class, they work for the benefit of the large financials (Goldman Sachs, JP Morgan, etc).

INFLATION IS INCREASE IN MONEY SUPPLY, which *eventually* causes a rise in prices, wages, etc.

Cayo Dave said...

Inflation is NOT necessarily an increase in the money supply. It can result from it, but it not the root cause of todays inflation expectations.
Commodity price rises, wage pressures, and energy costs are the cause of today's inflation worries..
I am not a realtor.
Maybe it is time for you to get a new economics textbook.

deepcgi said...

"they are not making any more land".

no, but they are making more houses aren't they? too many more from the looks of the home builder's stock prices.

Anonymous said...

I think there is some confusion as to the notion of cause and effect when it pertains to inflation.

Supply and demand on their own do not cause inflation. They are simply ancillary facets of the entire economic model.

The best way to explain how inflation is created is through this example:

Assume you have 10 one dollar bills on an island. And you have 10 items of equal value on the island as well. No other items or dollars enter or leave the area. So in essence, the mechanism is static. Each item in its current state has exactly the same intrinsic value.

Now let us assume that as time progresses, the perceived value of the items changes. Let us say one of those items is now deemed "more valuable" in relation to its peers. i.e., its value increases to $1.50 as opposed to being valued at one dollar. Now, because the amount of dollars on the island is finite, one or more of the other items on the island must now correspondingly decrease in value. Presumably, the item deemed "least valuable". So one of the items previously listed at $1.00 is now worth $0.50 cents because the money supply is fixed. So in this case, inflation is zero because a price increase of one item was compensated by a price decrease in another item.

Now suppose that the perveiyer of the low cost item does not want to decrease the price of his item and has the means to introduce an eleventh dollar into the static model. Now, instead of 10 one dollar bills, there are eleven. As such, he can maintain the cost of his item at $1 dollar without effecting the cost of the other item. But on a whole, the purchasing power of the dollars themselves has decreased. The model now re-sets itself at a new level. And this in a crux is what inflation is.

So from the standpoint of who causes inflation? The answer is: the suppliers of the currency. i.e. the Fed. Supply and demand can change individual pricing but cannot fundamental change inflation as a whole on their own. That can only be done through increases in the money supply.

Naturally, this is somewhat of a simplistic example. But the concept is sound. Inflation is an increase in the money supply and a subsequent decrease in purchasing power. Supply and demand are driven by the consumer. Inflation is driven by the Fed.

Anonymous said...

Both increasing money supply and increasing demand result in inflation. We are now experiencing both increasing demand in raw materials and money supply. Both of you are right.

Anonymous said...

Things I have learned about inflation:
The definition of inflation changed some years ago.
The Wikipedia definition is what gets used today. Price increases.
The older definition found in my college dictionary bought in the late 80s is the expansion of money/credit. (Austrian economics)
The FED is not government. They are bankers.
What definition of inflation does the FED use? I don't know.

From what I hear. Austrian economics is no longer tought in the US. Even current Phd canidates don't know what it is.
Probably why there is so much confusion about inflation.

Anonymous said...

Inflation IS the increase in money supply. The Fed tries to obfuscate this and the government lies about the rate of inflation every day. Thank you for the elementary illustration of inflation. "Brainwashing" is a loaded term, but by reading these posts, that is clearly what has happened in the education of our youth. The government and their co-conspirators at the Fed will soon be telling the sheeple that wage increases cause inflation. My hope is that all citizens will not be afraid to find the truth behind that PR campaign.

Anonymous said...

I would like to thank Mr. Anonymous-Inflation-Expert for imparting his wisdom amongst all of us morons. Our shoes would surely fall off if we didn't have him to help us tie their strings. It's amazing that we are able to live our lives without having him around to educate us on such high-falutin' concepts as "inflation".

Anonymous said...

As some said, the definition of inflation is an increase of money supply relative to the economy size. Of course, the Fed creates inflation. Look at M3. M3 has been increasing 10-13% per year. That is how much the dollar has been devaluating. The interest rate is much below the real inflation. If you have cash and collect interest, you are losing money each month. The effect of inflation is an increase in consumers' good prices. The Fed manipulates the CPI (Consumer Price Index)and under-reports the inflation effects so as to help the government to sell the treasury bonds.

Edible City said...

I agree with all the others who understand the truth about economics - increased money supply causes inflation. Prices don't rise in the long term in a fixed money supply. The reason it appears that prices have risen in the past 70 years is because the value of the dollar has fallen. If you get enough countries in the world to peg their currencies to the dollar, then it appears that the value of the dollar is fine - comparatively speaking. Go look at the first graph on this web page It shows the direct relationship that the money supply has with inflation. When the money supply is fixed, the cost of goods tend to fall over time as businesses tend to pay off capital expenditures and become more efficient. There is no such thing as market based inflation except maybe in the short run. When the supply of goods is less than the demand for those goods, prices will rise but only temporarily. Either the businesses that are currently producing those goods will increase production which means hiring more workers which means an increase in the wages to those workers, or a new business will enter to fill the void and most likely the new business will be using newer more efficient equipment and may therefore be able to produce a cheaper product. There is an instant where prices will rise and no drop and that is when a resource becomes scarce, but in this case (such as oil if it is indeed becoming as scarce as some say) (they say necessity is the mother of invention) a new product that can fulfill the same purpose (biodiesel, fuel cells, electric cars, etc...) that previously were too expensive to produce to penetrate the market effectively will become a comparative alternative to the scarce resource until it finally overtakes the scarce resource in terms of lower prices. There are other factors which come into play in our current market, such as environmentalists, subsidies, old entrenched corporations, etc... But under a completely Free Market system, this is how it works and there is no inflation except in the short run or with a scarce resource. It's not real hard to understand if you just think about all the pieces - like a puzzle.


Anonymous said...

Well, if inflation runs wild then house price will not be down for long. It is because house is a hard asset. When it costs more to build the same house you bought yesterday then I dont see how the house tomorrow can be sold for a cheaper price. As a result, in free market model, the Fed doesnot have to do anything to bail the housing buble. The market itself will adjust up to the point that price of a new house equal to the real cost of building it. There are three basic costs of building a new house. Cost of land, cost of material and cost of labor. When there is inflation, the cost of material and labor will definitely increase to catch up with inflation. Cost of land is the only element that can be and had been over valued in recent years due to continuing increase in price speculation from real estate investors and home owners. So while the cost of land which typically equal to 20% of the total cost of a new house, will be decreased while the buble burst. The price of labor and material will continue to increase. This is the reason why house price can not and will not fall to more than 20% no matter what happen to the interest rate.

falconview said...

Soo, inflation doesn't come from the FED printing currency out of thin air--increasing the overall money supply and reducing its overall value? The 41 billion given to Citi by the FED, significantly increasing the money supply, has nothing to do with the reduced value of the dollar? The Federal Reserve can’t bail out the real estate bubble because printing valueless currency to "fill the gap" merely dilutes the value of the overall money supply--displacing some of its value from the individual to the banks (basically indirect robbery). However, the FED can’t dilute enough value out of the overall money supply to cover the losses of the lending agencies no matter how much interest rates are meddled with. The only benefit of printing 41 billion extra dollars is the time lag between when the 41 billion was printed (at value) and when the diluted value will impact the market. The FED has created the perfect storm and its time to pay the piper…the question the FED is deciding now is who is going to foot the bill. The value of the currency they printed has to come from somewhere: but where?