What will happen to Home Prices in the Experimental Economy?

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This article is a follow up to my Why have mortgage rates spiked? article published two weeks ago, and sets out some thoughts about the outlook for residential real estate as we enter an Experimental Economy.

What is an Experimental Economy?
Let’s try to compare the economy in a recession to a car pulling a trailer, with a full load of passengers, while going uphill.  What does the driver do? To offset the gradient and the weight being pulled, she pushes on the accelerator pedal, the extra effort allowing her to maintain speed. And when she gets to the top of the hill? She eases off the pedal so that she can avoid speeding and the risk of losing control.

Now, let’s look at the economy. As we emerged from The Great Recession, the Federal Reserve (Fed), understanding that the economy was facing a sharp incline, had its foot hard down on the accelerator (cheap and plentiful money), dragging the car (economy) with its trailer (unemployment) up the incline.

After an initial period, the car slowly regained its speed and as it neared the top of the hill the driver started to ease off on the accelerator (raising interest rates and buying fewer Government securities – Treasuries).

And then, the car reached the top of the hill (historically low levels of unemployment, an economy growing steadily).  So, what does the driver do now? Well, based upon historical evidence, the driver (Fed) raises interest rates, while the Government tries to run a budget surplus to squirrel away funds for the next recession.

The Fed has done its part, but the Government, as in Congress, has decided that it is time for an Experimental Economy. Instead of taking the foot off the accelerator, Congress has passed a series of tax cuts and spending increases which will more than double the Budget Deficit. Rather than easing up on the accelerator, Congress has decided to push its foot down even harder.

I call what we are entering now the Experimental Economy, the experiment being that we are betting that the tax cuts and spending increases will lead to faster economic growth, which in turn will reduce the budget deficit.

It’s different this time because….
During periods of strong movement, either up or down, whether in stock markets or economies, one frequently hears pundits explaining why “this time it is different.”

During the yearly years of Quantitative Easing (monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply) many economists forecast that such an unprecedented increase in the money supply would inevitably lead to renewed inflation.

That did not happen for a variety of reasons: the depth of the recession in the US and the longer recession in Europe, the emergence of the US as the world’s largest oil producer. The result was that the longer that inflation did not recur the more the experts claimed that “this time it’s different.”

But, as Winston Churchill said: “Those who fail to learn from history are condemned to repeat it.”

What could go wrong with the Experimental Economy
Those who are predicting that strong growth will follow from the major stimulus to the economy may be proved right. If not, the risk is that stimulating the economy at a time of full employment will cause the Fed to raise interest rates aggressively and choke off the hoped for economic growth.

If you have been watching the Olympics, you may have seen the bobsleigh or bobsled events. Stepping on the gas at the top of the economic hill might be compared to jumping in a bobsleigh and hurtling down the track.

In this photo of a 4 man team, the man at the back – the brakeman – appears to have his head down, as if in prayer. I am wondering if he is the Federal Reserve Chairman who has just been told that Congress has passed another spending bill.

At least the traditional bobsleigh has a sold frame, with a driver and brakeman. Let’s hope the economy resembles the 4 man bob rather than the skeleton bobsleigh below.

Why Treasury yields may continue to rise
I have written many times in recent years that the law of supply and demand has applied to home prices, in comments like: “economic growth, low interest rates, strong demand and low supply will lead to higher prices.”

Whether or not inflation does increase beyond the Fed’s 2% target, there is going to be a major increase in the amount of Treasuries that need to be sold this year to finance the sharply increased budget deficit. And this will occur when the Fed has switched from being a buyer of Treasuries to a seller, and when the projected weakness of the dollar makes buying anything in the US less attractive to foreign investors.

If the supply increases and demand decreases, then prices should go down – which in bond markets means higher interest rates.

What will happen to residential real estate prices
While many commentators have expressed the hope that rising interest rates might slow the demand for real estate, there is a converse argument that recent tax changes may encourage people to stay in their existing homes. A longer-term encouraging sign is the recent sharp increase in both housing starts and building permits, but in the short-term demand seems set to continue to outstrip supply.

And historically, real assets like homes have benefited in times of inflation.

If you – or somebody you know – are considering buying or selling a home and have questions about the market and/or current home prices, please contact Andrew Oliver on 617.834.8205 or Kathleen Murphy on 603.498.6817.

If you are looking to buy, we will contact you immediately when a house that meets your needs is available. In this market you need to have somebody looking after your interests.

Are you thinking about selling? Read  Which broker should I choose to sell my house?

Andrew Oliver and Kathleen Murphy are Realtors with Harborside Sotheby’s International Realty. Each Office Is Independently Owned and Operated

@OliverReports