After Katrina, Calm at the Fed?
By Michael Wallace
In a speech made just prior to the onslaught of Hurricane Katrina, Federal Reserve Chairman Alan Greenspan voiced discomfort with low-risk premiums in "stocks, bonds and, more recently, of homes". Having made previous references to "froth" in the regional real-estate market and been joined by other policymakers in raising concern about the housing juggernaut, the Fed chief made it abundantly clear the central bank's focus was returning to its mandate of containing inflation over sustaining growth.
But has the Fed's view changed in the storm's aftermath? Not likely. In the weeks following Katrina's Aug. 29 landfall, Fed officials have continued to echo concerns about risks of rising core inflation and the housing market.
The Fed chief's trepidation appears to extend to the financial risk from the growth of mortgage giants Fannie Mae (FNM ) and Freddie Mac (FRE ). He rebuked Congress for not putting meaningful limits on the housing agencies in a Sept. 2 letter to Senator Robert Bennett, according to The Wall Street Journal.
The storm shouldn't inhibit the sector's long-running expansion. While Katrina has had a devastating impact on the local housing stock in the New Orleans region, rebuilding efforts will have a wider impact in the Gulf region and nationally over time, as demand drives rapid rebuilding.
Past events of lesser magnitude suggest that the housing sector in the affected region will bounce back, though the extensive flood damage has slowed the response to Katrina and will stretch out the recovery period in the immediate region.
As is usually evident with existing and new home sales reports, hurricanes generally depress sales only during the "strike month" -- and even then the impact tends to be restrained, with fairly dispersed experiences in the ensuing months with different hurricanes. With Katrina, we would expect a larger, though more delayed, rebound.
The National Association of Realtors (NAR) raised its housing sector forecasts in the wake of the storm, though it suggested that the rebuilding in the Gulf region would create upward pressure on prices for raw materials more broadly, which may restrain growth.
With a slower rise in mortgage rates, home sales and prices are expected to increase nationally. The NAR estimated that existing-home sales will increase by 3.4%, to 7.02 million, while new home sales will rise 6.7%, to 1.28 million, in 2005 -- both "low ball" estimates in our view, but which are record levels nevertheless.
The group expects home prices to continue their upward path as well. The median existing home price is expected to rise 10.8%, to $205,000, while median new home prices are likely to climb 3.8%, to $229,000, for the calendar year.
The NAR expects the average 30-year fixed mortgage rate to hit 5.9% by the fourth quarter of 2005 and 6.7% by the end of 2006, vs. the current 5.75%. Taking a macro view, the group sees gross domestic product initially slowing to 2.3% in the third quarter, before rebounding to 2.7% in the fourth and back to 3.8% in 2006.
Our own forecasts at Action Economics reveal a slightly stronger near-term trajectory for housing, GDP, and interest rates, but with a similar profile.
Our third-quarter GDP estimate sits at 3.5%, though we suspect this would have been a 4.4% gain had it not been for a 0.7% subtraction from Katrina, and another 0.2% reduction from the Boeing (BA ) machinists' strike.
By our estimates, GDP will post 3.9% growth in the fourth quarter, as the lagged effects of Katrina on gasoline prices and sustained dislocations in the New Orleans employment base continue to weigh on economic growth, despite the historic tendency for monthly and quarterly growth figures to bounce quickly after a storm.
We expect a bounce in the first half of 2006 to boost GDP growth into the 4%-4.5% range, as the national economy responds to increased demand for construction materials, equipment, and support services associated with rebuilding in Louisiana and Mississippi.
A recent source of support for the housing market, beyond strength in demand from hurricane victims, has been the recent declines in floating and fixed mortgage rates.
Indeed, rates fell for four consecutive weeks until Freddie Mac reported that the 30-year fixed-rate mortgage rose to an average 5.74% in the week ended Sept. 15 -- one basis point below 5.75% in the year-earlier week.
To this point the Fed has been content to indirectly "manage" exuberance in the housing market by warning against laxity and excess by domestic lenders and foreign investors, such as the interest-only, no-down payment schemes combined with adjustable mortgages, which leave borrowers at risk if rates surge.
Greenspan expects the housing boom will "eventually simmer down" of its own accord, and in the process slow consumption growth as home equity extraction (i.e., consumers' borrowing under home equity loans and lines of credit) eases. He doubts the Fed will target asset (home) prices anytime soon, though such prices were already an "integral part" of the Fed's evaluation process.
SIGNS OF A PAUSE?
Katrina will give the Fed cover to manage these risks with greater latitude, though it has likely postponed risk of a more aggressive policy stance.
It seems likely the Federal Open Market Committee, the Fed's policymaking arm, will make some sort of sympathetic reference to Katrina's impact in its Sept. 20 statement, which some market players could take as a signal for a pause in the pace of rate hikes.
We still see Greenspan & Co. sticking to its "accommodative and measured pace" -- i.e., more small hikes until yearend. For now, though, it's clear that the robust housing sector -- and the risk of big energy price gains creeping into core inflation -- remain on the Fed's front burner, as much as the near-term fallout from Hurricane Katrina.
Tame readings on consumer and producer prices will go only part way to assuaging these concerns, as the Fed will need to look forward to sort through the debris of post-Katrina readings.
One early, discouraging sign: The "prices paid" component of the Philadelphia Fed's September survey of business conditions, released Sept. 15, doubled in the aftermath of Katrina.
Of course, there is one silver lining after the storm's fury: A pick-up in activity in the housing sector, along with falling rates, should help provide a cushion against any hurricane-borne slowdown in the broader economy.
Wallace is global market strategist for Action Economics