The Lehmann Letter ©
The stock market retreated slightly today, but all the major indexes have passed milestones lately: The Dow 9000, NASDAQ 2000 and the S&P 1000. We’re far ahead of recent bottoms.
But that doesn’t guarantee continued steep and strong gains. The economy and corporate earnings must improve dramatically, and that’s linked to residential real estate’s recovery. Remember that housing led us into the morass. It’s hard to envision a strong recovery while real estate remains weak.
The Federal Reserve has a role to play. The Fed promotes economic expansion by reducing interest rates, thereby stimulating borrowing and spending. If as a result prices rise too rapidly due to excess demand, the Fed raises interest rates to choke off borrowing and surplus spending. The Fed has a difficult job: Trying to promote growth without instigating inflation and trying to prevent inflation without binging on recession.
Think of the economy the way you’d think of a frisky horse. The economy breaks into a gallop (boom) as soon as the rider (the Fed) lets the reins dangle (low interest rates). But the economy comes to a halt (recession) when the Fed pulls back on the reins (high interest rates). The skilled equestrian knows how to handle those reins.
The Fed has obliged today’s optimists by pushing rates into the sub-basement. Since the Fed’s policy proved successful in the past, what imperils it today?
The answer lies in the consequences of the 2001 through 2003 rate cuts that rescued us from the 2001 recession. In past recoveries the Fed depressed rates briefly and raised them as soon as inflation threatened. Since inflation – as conventionally measured – did not threaten in 2002 through 2004, the Fed held rates down even though home prices rose rapidly. The consequence was the record real-estate boom that peaked in 2006. Recession began in 2007 when the boom collapsed under its own weight.
Low interest rates won’t prompt recovery today because high interest rates did not instigate recession in 2007. The Fed let the boom run from 2004 through 2007 until it collapsed from exhaustion. (That is, until home prices rose beyond any reasonable relation to rental values.) Since high interest rates did not instigate recession, low rates will have limited effectiveness in spurring recovery.
Returning to the earlier analogy, it was as if the Fed let rates dangle for so long (in 2002 – 2005) that the horse ran until it could go no further. Now the horse must remain in the barn for a good rest and some water and oats. Dangling the interest-rate reins won’t get him to move for quite some time.
That is, building won’t recover strongly until the foreclosures cease and home prices stabilize. When the number of vacant homes begins to dwindle, builders’ confidence will return and construction will recuperate in earnest. Then, and only then, will the private sector commence a true recovery.
For the time being, the horse is in the barn.
© 2009 Michael B. Lehmann