The Fed: A New Bubble in the Making?
Call it the double bubble. A housing bubble may be developing--right behind the Nasdaq bubble. Although overall stock prices are down 12% and the Nasdaq is off 25% since the start of 2001, average house prices are rising at an annual rate of 8%. In fact, falling equities have led many well-heeled investors to shift money into residential real estate. Robert J. Shiller, author of Irrational Exuberance, which predicted the Nasdaq crash a year before it happened, now warns that a psychological frenzy not unlike tech mania is gripping housing. It appears that the Federal Reserve's dramatic rate-cutting campaign to revive the economy may be overheating housing. Perhaps the Fed should take a time-out after the latest cut in interest rates to cool off housing--before it's too late. For the vast majority of families, a house is a more important investment than stocks. It could take a far smaller percentage drop in property prices to deliver an equally devastating blow to the economy. Some key financial institutions could be badly hurt.
The bursting of the Nasdaq bubble hit Corporate America right between the eyes. A housing crash would slam consumers. Consumer spending has been sustaining the economy ever since technology and manufacturing companies began to pare back their capital investments. Many families are carrying a heavy load of debt to finance that spending. They count the value of their house as real savings to support that debt. If a big chunk of that value disappears, consumer spending could easily dry up. For those families that have already been stung with massive equity losses in their mutual funds and 401(k)s, this second hit from a housing drop could be financially catastrophic.
Lower interest rates could also send the dollar reeling. The greenback is already softening against the euro and the yen. This is good for the exports and profits of multinationals. But a sliding currency often becomes a plummeting one. A rapidly falling dollar could fast undermine the stock market and future capital investment by drying up foreign capital flows.
Most important, lower short-term interest rates can't generate the one thing essential to rekindling growth: corporate investment. Tech and manufacturing must work through their inventories before they increase production. Telecoms must consolidate before they can buy new high-tech gear. Companies must cut costs and recover from their profits recession before they hire again. Lower rates can't help much here.
The Conference Board's index of leading indicators rose in July for a fourth straight month, suggesting that growth could pick up before yearend. This may be a judicious moment for the Fed to just watch and wait. There still may be time to prevent a double bubble.