An Apple-a-Day
There’s an old tale of many economic cycles ago, about an enterprising mendicant/street vendor who sold apples on the street corner for 25 cents. Each day, a well-to-do banker would walk by and, without ever speaking, would leave a quarter without taking an apple. The same routine went on each and every workday for more than 10 years. One day in October, the banker passed by the street vendor and left his quarter as usual. Speaking to the banker for the first time, the vendor exclaimed, “Sir, I do appreciate all of the business you have given me over the years, but I must inform you that the price of apples has increased to 50 cents.”

Banker jokes aside, recent Fed-speak has been uniformly hawkish on the subject of inflation. Dialogue has become increasingly cautious and metaphorical. Richard Fisher, president of the Federal Reserve Bank of Dallas, provided an excellent example of recent assertions, stating that, “We cannot let the equivalent of sclerosis block the arteries and disrupt the workings of the economy, nor can we let the inflation virus infect the blood supply and poison the system.”
He further offered his view that inflation is moving closer to the “upper end of the Fed’s tolerance zone.” Adding some granularity to the Fed’s position, William Poole, president of the Federal Reserve Bank of St. Louis, stated that it is reasonable to assume that two more increases in the funds rate are in store for this year.

The inflation alarm is starting to sound on a worldwide scale. At 2.4%, the United Kingdom’s August annualized inflation rate was the highest reported in more than eight years. Jean-Claude Trichet, president of the European Central Bank (ECB), stated that he was prepared to raise interest rates “at any time.” The ECB has not increased rates in over five years.

Whether or not rising prices will quickly lead to softening demand remains to be seen, particularly at the finished goods level. Much depends on consumer demand, which is largely driven by home prices. In 2004, homeowners borrowed over $600 billion against their residences. That amounted to approximately 7.0% of disposable income and dwarfed the economic impact of recent tax cuts.

For the month of August, the Fed’s preferred inflation index—the personal consumption index—rose at an annualized rate of 2.4%. For the trailing 12-month period, the index has increased by 2.0%—the Fed’s stated upper limit of tolerance. We know, from the September 20 FOMC minutes, that leaving the funds rate unchanged would have “the potential to mislead the public both about the Committee's perceptions of the fundamental strength and resilience of the economy and about its commitment to fostering price stability.'' As short-term rates rise, the yield curve continues to toy with an inversion. Clearly, the long-end of the curve will be watching for the degree of monetary resolve coming from the Fed.

Housing and Monetary Policy
On September 26, the Fed’s Board of Governors released a discussion paper entitled, “House Prices and Monetary: A Cross-Country Study.” The paper surveyed pricing conditions in 18 different global markets over the past 25 years. Not surprisingly, the rate and direction of change in the price of housing parallels that of longer-term fixed-rate investments. Interest rates and global business cycles are the primary determinants.
The paper also presented the historical observation that housing prices characteristically peak between 12 and 18 months after the initiation of a tighter monetary policy.

There are some other salient observations:

• When U.S. housing prices are out of line with equilibrium values, they tend to revert to historical norms. In moving back to their historical trend, the price component of price-to-rent ratios tends to adjust at faster rates than the rent component.
  
• Money supply growth is considerably lower in periods after a peak in housing prices.
  
• Equity prices tend to decline earlier and faster than declines in housing prices, yet they rebound while housing prices continue to decline.
  
• Current account deficits widen at least two years before peaks in housing prices and reach an average of 2.5% at the peak.
  
• Immigration and growth rates in working-age populations appear to play a significant role in housing prices. In recent years, Germany and Japan (countries that have experienced population declines) have sustained declines in housing prices concomitant with increases that took place in other industrialized countries.
  
• In previous global housing cycles, significant declines in asset prices have been associated with increases in non-performing loans and weakened balance sheets. Nonetheless, residential mortgages are perceived as having little risk due to the syndication effect of securitization and the facts that:
  • LTV ratios typically fall as a loan ages
  • Historically, residential mortgages are less volatile than commercial mortgages.

Figure 1 highlights some evidence that, over various points in economic cycles, residential mortgage assets have sustained less risk variability than other loan categories.

Going forward, it may be wise to incorporate contingent growth strategies into your institution’s dynamic modeling process in the event growth in certain asset categories doesn’t go as planned. The same would apply to interest rates. Have you simulated your institution’s performance against a possible inverted yield curve?

This month’s forward curve analysis shows the continued expectation of a flat yield curve, with respective expected Fed funds rates three, six, and 12 months out, at approximately 4.32%, 4.48% and 4.62%.

The possibility of a continued flattening of the yield curve has prompted increased interest in the Seattle Bank’s putable advance offerings. The Seattle Bank recently offered a special situation 10-year, non-put 3-month advance to members. Stay tuned for further offerings in this area.

Home Hedging – Time for a Trim?
With prospects of housing bubbles dominating the headlines, short of calling the realtor, many homeowners are turning furrowed brows into action. Not surprisingly, new products are being offered the consumer, designed to hedge the possible effects of falling residential real estate prices. For example, Chicago Mercantile Exchange plans on announcing, during the second quarter of 2006, futures contracts based upon home prices in 10 different cities. Who knows, maybe at your next block party, you will be able to recite your home’s current price-to-rent multiple!

John Biestman is assistant vice president, IMS consultative sales advisor at the Federal Home Loan Bank of Seattle.

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