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Commentary
“A Nickel Ain’t Worth a Dime Anymore” - Yogi Berra
Minutes of the February 1 – 2 meeting of the Federal Reserve’s
Open Market Committee provide some interesting insights and underscore
the notion that policy moves will greatly depend upon upcoming data.
Committee minutes stated: “The real federal funds rate was generally
seen as remaining below levels that might reasonably be associated with
maintaining a stable inflation rate over the medium run.” However,
the committee went on record as believing that core inflation would remain
low and stable, assuming that monetary policy continued to be less accommodative.
The core personal consumption expenditures (pce) deflator index, a measure
of inflation favored by the Federal Reserve, has increased by 1.6% over
the past 12 months, with January’s increase of 0.3% representing
the largest one-month gain since October 2001. Rising prices are largely
emanating from the oil and commodity sectors, which may be adjusting
due to the continued weakness of the dollar.
Two possible paths could emerge from the impact of rising prices: (1)
consumer spending could be suppressed, or (2) “cost-push” inflation
could increase inflationary pressures throughout the economy. In the
former, any reduction in demand caused by rising commodity prices might
be construed as a surrogate, or replacement for Fed tightening.
Still, there is the question of unmeasured inflation: housing prices,
tight credit spreads, and a firming stock market. No doubt that these
variables are helping the U.S. economy grow at an above-trend pace. Recent
evidence: (1) a 262,000 increase in non-farm payroll—the largest
gain since last October; (2) a 1.6% annualized increase in the amount
of hours worked over the past three months; (3) the highest rate of wholesale
price increases (excluding food and energy costs) in over six years.
Nonetheless, on the labor cost front, we have yet to see material wage
pressures. Adjusted for inflation, weekly earnings during the month of
January fell by .2%. This metric has declined during three of the past
four months. As Michael Moskow, president of the Federal Reserve Bank
of Chicago stated, “So far at least, wage pressures have not been
higher than one would expect on the basis of the usual measures of labor
market slackness.”
We know that the Fed is keeping a close watch on unit labor costs, which
rose by 2.3% during the fourth quarter. Productivity, which rose by 4.4%
during 2004, also remains under the microscope. Not many expect continued
improvement in this variable, at this point in the business cycle.
Fear that inflation will be prompted by waning productivity, a weaker
dollar, and rising commodity prices has prompted an interesting debate
within the FOMC. Several regional presidents, including Janet Yellen
and Ben Bernanke, have broached the potential benefits of establishing
specific inflation targets as the principal guide in formulating interest
rate policy. Remember that the current beacons of monetary policy, as
mandated by Congress, consist of two qualitative goals: (1) maximized
and sustainable employment, and (2) wage and price stability. Central
bank inflation targeting has been successful when applied to the formerly
inflation-ridden economies of the United Kingdom, New Zealand, and Chile.
However, the jury is still out on the impact that inflation targeting
would have in cases where price pressures are low and contained. We’ll
see how this discussion evolves in future meetings.
What’s Your Zip Code’s Price/Earnings Ratio?
Housing prices can affect a central bank’s monetary policy. Bank
of England officials have often noted that rising housing prices have
been a prime catalyst for the successive rate increases they’ve
been seeing for well over a year.
In his latest round of Congressional testimony, Alan Greenspan once
again noted the possibility of housing bubbles in “certain areas” with
the possibility of declining prices. PMI Mortgage Insurance Co.’s
Residential Real Estate Risk Index (a statistical model that looks at
such variables as household income, median mortgage payments, and economic
activity) recently hit our desk with some interesting observations.
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The good news: There is a 16.1% chance
of an overall decline in housing prices in the nation’s 50
largest metropolitan areas over the next two years. That’s
a reduction from the reading of 18.6% from the index of six months
ago.
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The bad news: In certain areas of the country, there is “a
further misalignment of home prices with long-term economic fundamentals.” What’s
the cause? Rising home prices relative to income growth. How do
the probabilities stack up? The Boston metropolitan area index
indicates
a 53.3% probability of a housing price decline over the next two
years. One year ago, the ratio stood at 23.3%. Many California
markets do not fare much better. Respective probabilities of price
declines
for the San Jose, San Francisco/Oakland, and San Diego markets
are 53.0%, 47.9%, and 43.3%.
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More good news (relatively speaking): The markets within the 12th
District that were surveyed (Seattle/Tacoma/Bellevue (9.7%), Salt
Lake City (6.1%) and Portland/Vancouver/Beaverton (10.9%), all supported
probabilities that were well below the national average. |
It’s interesting to look at residential real estate valuations
in terms of the ratio of prices to potential rental yield. As is the
case with any financial asset, aside from the non-financial benefits
(pride of ownership, proximity to friends and relatives, etc.), a residential
asset should be valued on the basis of future rental income (in the case
of an investor) or rent saved (in the case of an occupying owner). The
ratio of price-to-rent can change in one of two ways: (1) changes in
rent (as measured by the Bureau of Labor Statistics’ Owners’ Equivalent
Rent Index), or (2) changes in anticipated returns (as measured by the
OFHEO Existing Home Sales Price Index). This approach is quite similar
to a total rate-of-return analysis that one might apply to a stock or
a bond.
Figure 1 shows that the price-to-rent ratio is roughly 20% above its
average over the past 22 years. In an October 2004 report, entitled “House
Prices and Fundamental Value,” the Federal Reserve Bank of San
Francisco analyzed the past 22 years in terms of how much of the variability
in the price-to-rent ratio was ascribed to movements related to future
expected returns versus rental growth rates. The result of the study:
most of the variability in the price-to-rent ratio was due to changes
in future returns, as opposed to changes in rent levels. The conclusion:
assuming that you can’t defy the laws of physics in the long run,
the ratio will return to its longer-term average via slower housing appreciation,
rather than rising rents. So much the better if you’re in a safe
zip code!
Figure 1. U.S. Housing Market Price/Rent
Ratio: 1982 – 2004
Source: OFHEO Existing Home Sales Price Index,
Bureau of Labor Statistics Owner’s Equivalent Rent Index
Scary Carry
Not surprisingly, the term Fed funds market
is projecting a continued march to a point of monetary neutrality that
has yet to be quantified.
Respective June 30 and December 31, 2005, levels are now 3.25% and 3.89%.
The likely scenario continues to call for a 25-basis-point-per meeting
tightening and a 2.75% Fed funds rate to be promulgated at the March
22 meeting—the seventh consecutive rate increase since June of
last year.
While the short end continues its climb, the longer end of the yield
curve (which has actually dropped by 50 basis points since the Fed began
its campaign last June) continues its relative stagnation. The spread
between two-year and 10-year treasuries continues to flatten and now
stands at 72 basis points. On the subject of nonplused long-term yields,
Mr. Greenspan stated it best: “Bond price movements may be a short-term
aberration, but it will be some time before we are able to better judge
the forces underlying recent experience. For the moment, the broadly
unanticipated behavior of world bond markets remains a conundrum.” While “conundrum” may
sound like a new brand of ibuprofen or industrial-strength floor cleaner,
Webster’s defines it as “a question or problem having only
a conjectural answer.” On that note, during his recent Humphrey-Hawkins
testimony, Mr. Greenspan conjectured that the likely cause of intransigent
bond yields is a shortage of viable global savings options (read, a surfeit
of global savings), weak credit demand, or low inflation.
The disappearance of the carry trade has been a source of concern to
many financial institutions. Accordingly, this month’s feature
article highlights several strategies aimed at enhancing net interest
income in the face of a flattening yield curve.
John Biestman is assistant vice president, IMS consultative
sales advisor at the Federal Home Loan Bank of Seattle.
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