Another Fed Rate Hike will Devastate Housing Market

NEW YORK CITY (BusinessWeek) June 7, 2007 — It's getting harder and harder for real estate agents to put a happy face on the market. Sales are slowing, prices are falling, and the backlog of unsold homes is rising fast. And now it's suddenly looking like the Federal Reserve will raise interest rates again.

As recently as June 2, the real estate biz was breathing a sigh of relief that the Fed was finally through with raising rates, after 16 quarter-point increases. But then Federal Reserve Chairman Ben Bernanke gave a hawkish anti-inflation speech on June 5 that strongly signaled another increase in the federal funds rate at the next rate-setting meeting on June 29.

Bernanke's gladiator-like aggressiveness on inflation is producing scowls at the National Association of Realtors, which worries that higher mortgage rates will make the housing market even softer. The group put out a public statement on the issue this week, in which David Lereah, the Realtors' chief economist, said: "This is a time for the Fed to pause on rate hikes because we have some interest-sensitive housing markets that have become vulnerable."

Lereah couched his plea for a "pause" in rate hikes with upbeat remarks about how 2006 stands to be the third-best year ever for home sales. He even said that the slowdown "is a good thing because slower appreciation will help to preserve long-term affordability." But it's clear that the Realtors' association isn't happy with the way things are unfolding. It predicts that existing-home sales will drop 6.8% this year, to 6.6 million, while new-home sales will tumble 13.4%, to 1.11 million.

Up until his June 5 speech, Bernanke gave the impression that he was being careful not to tank the housing market, vowing in congressional testimony on Apr. 27 to "monitor housing markets closely." Since then, though, the housing market has done nothing but weaken, points out David Rosenberg, Merrill Lynch's chief North American economist. Housing starts are down over the past three months at a 56% annual rate. "So Mr. Bernanke is 'monitoring,' all right," Rosenberg wrote in a report on June 7. "He's monitoring the collapse of the housing market, and by the sounds of it he wants to reinforce the bear market already under way."

Most economists don't think Bernanke is actually trying to reinforce a bear market in housing, but they do say that the market has turned decidedly bearish. Richard DeKaser, chief economist of National City in Cleveland, calculates that over the six months through April, median sales prices have fallen at a 4.4% annual rate for new homes and at a 5.6% annual rate for existing homes. (To do that calculation, DeKaser had to make his own seasonal adjustment to the numbers. As reported, the data show only year-over-year price changes, which are still positive.)

Real estate stocks have been on a steep slide. Shares fell further this week after a downgrade by Wachovia Securities. Since their peaks last summer, Pulte Homes, D.R. Horton, Lennar, KB Homes, and Toll Brothers, among others, have lost anywhere from one-third to more than a half of their stock market values. In a note to clients, A.G. Edwards & Sons wrote, "If it is not already painfully apparent, the soft-landing thesis for the homebuilding industry is dead."

One more quarter-point increase in the federal funds rate may not seem like it could have much of an effect on housing. But DeKaser points out that the market still hasn't fully adjusted to the rate hikes that have already occurred. In fact, he says, according to an analysis that he plans to release next week, some of the most overvalued markets are continuing to see some big increases in prices. That's setting them up for an even bigger fall to come, he says.

Mortgage bankers also see the market slowing, but they aren't echoing Realtors in asking for a pause in rates. That could be because they, like the Fed, hate inflation — it erodes the value of the fixed-rate loans they make. "We've never publicly given the Fed instruction on how to conduct monetary policy," Douglas Duncan, chief economist of the Mortgage Bankers Assn., said June 7.

That said, Duncan noted there is still a danger that the Fed could overshoot and raise rates so high that they hurt the job market, which is the real underpinning of housing. "If employment falls, that could precipitate price declines and all the speculation that's supported the market would be expunged," says DeKaser. "You could see things swing the other way to where there's an irrational fear."

To put it differently, some economists say: What goes up must come down. One housing bear, Ian Shepherdson, chief U.S. economist for High-Frequency Economics in Valhalla, N.Y., wrote June 6: "Ultimately, we expect the level of home sales to head down to, or even below, the long-term trend. When bubbles burst, they usually burst properly. Gentle deflations are rare."