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Federal Reserve Keeps Mortgage Market Smooth

Posted Wednesday, September 17, 2008

The Fed has done an impressive job of maintaining liquidity in financial markets following the takeover of Fannie Mae and Freddie Mac, as well as the collapse of Lehman Brothers, Merrill Lynch, and now AIG. Mortgage interest rates remain at extraordinarily low levels, especially in a context where CPI inflation is running at more than a 5 percent annual rate.

This will not turn around the housing market. In fact, the financial turmoil is far from over. However, the Fed's actions have prevented a credit crunch from developing, which would have made the situation in the housing market and the economy as a whole much worse.

While headline inflation fell in yesterday's CPI report, the news likely would have concerned the Fed, if it were not for so much evidence of economic weakness. The core inflation rate was 0.2 percent in August, bringing the annual rate over the last quarter to 3.4 percent. This rate is being held down by over-supply in the housing market, which is depressing rents. The annual rate of inflation in the owners' equivalent rent (OER) component of the CPI has risen at just a 2.1 percent annual rate over the last quarter. If OER were pulled out of the core CPI, it would have risen at a 4.1 percent annual rate over the last quarter.

It is difficult to assess the likely future course for inflation. Falling energy prices will dampen inflationary pressures, but past increases have not been fully passed on. The core intermediate goods index is still rising rapidly. It rose by 1.7 percent in August and has risen at a 21.7 percent annual rate over the last quarter. However, the weak labor market is causing nominal wage growth to slow from rates that were already well below the inflation rate.

The net in this story is that core inflation is likely to be near 3.0 percent for the immediate future. This is high enough that the Fed is likely to feel somewhat concerned about lowering interest rates. Real interest rates are already extraordinarily low with the 10-year Treasury rate below the CPI measure of inflation.  

The immediate situation in the housing market is continuing to deteriorate. There were 303,879 foreclosure actions in August, a 12 percent increase from July and 27 percent increase from the year ago pace. This corresponds to an annual rate of 3.6 million actions a year. If roughly half of these actions are associated with a loss of a house, this implies that 1.8 million families will be forced out of their homes over the next year at the current foreclosure rate. (Some of these foreclosures are on investment properties, so the actual numbers are lower.)

California had 101,724 foreclosures in August, accounting for more than one-third of the foreclosures in the country, although Nevada had a somewhat higher foreclosure rate (1 for every 91 households as compared to 1 for every 130 for California). Arizona came in third, with 1 foreclosure for every 182 households.

These foreclosure rates are truly extraordinary and reflect a real meltdown in the housing market in these states. In Stockton, California, the city with the highest foreclosure rate, there was 1 foreclosure action for every 50 households. At this rate, almost one-quarter of households would face foreclosure over the course of a year. (The ratio is even more striking since one-third of households nationwide are renters.) House prices are certain to continue falling well into next year in these markets.

As remarkable as these foreclosures rates are, it is also striking that the foreclosure rates remain quite low in some markets that had seen sharp run-ups in price and have seen declines recently. Massachusetts is noteworthy in this respect with a foreclosure rate of 1 per 1,117 households. The price declines have been limited to date, so most homeowners facing difficultly with their mortgages are likely to have some equity. However given the weakness of the economy and the sharp gap between house prices and rent in the state, it is difficult to believe that there will not be more of a downturn in the housing market.
By Dean Baker