News and stuff

It now seems very likely that Greenspan and his cohorts at the Federal Open Market Committee(a misnomer if there ever was one) will make exceedingly cheap capital a thing of the past in the near future.

By historical standards, money will still likely remain cheap.

If you look at the volatile, but necessary, increases in the cost of fuel and food, the observed rate of 0.6% falls to 0.2%. No matter how you slice it, higher food and energy costs reduce consumers ability to buy other stuff. This coupled with record - or near record - levels of household debt to equity ratios could easily conspire to unravel this weak economic recovery.

It bears(no pun intended) to be reminded of the following facts:

Small hike in rates means big jolt

However, figures clearly show that households are loaded to the gills with debt, and even if interest rates only go up by a tad -- a highly unlikely outcome -- it will be enough to set off the worst credit crunch in decades. The more dependent on debt an economy becomes, the more harm will be done by a rise in interest rates. This was clearly seen in 2000, when it took only a 1.75-percentage-point increase in the federal funds rate to trigger the Nasdaq slump and a jolting pullback in business investment.

And the fed funds rate, currently at 1%, may have to rise by well over that amount to reach a level that dampens the inflationary pressures building in the economy. Why can we be so sure that such a move would hurt the economy?

First, it would slow mortgage-related lending and thus lead to a decline in house prices in many parts of the economy. In turn, that would damage the banking sector, which is far more exposed to mortgages than it has been in the past.

Debt growth has been heady. Outstanding household mortgages have been growing at 10% or over since the end of 2001, according to Fed statistics. All through 2003, mortgage growth was 13%-plus, which is a red-hot rate, given that the average growth rate for the last 20 years is 9%. Moreover, at the end of 1993, just before the 1994 rate hikes, mortgage debt was growing at only 6%.

The impact of this debt growth on house prices has been to push them up to ridiculous levels. House prices were rising by 8% nationally at the end of last year and at much higher rates in large states like California (13.8%), New York (11.62%) and Florida (11.34%). The 20-year average nationwide growth rate is only 4.8%, and at the end of 1993 house prices were only going up by 3%, clearly indicating that this time is different.

Those vulnerable household budgets

There are other indications that house prices are way too high. Looking at the value of residential real estate as a percentage of disposable personal income is a nice way of showing how out of whack prices have gotten with incomes. That ratio is now at 182%, which is over 20 percentage points higher than its last peak in the late '80s, just before the last real estate bubble burst, Paul Kasriel, economist at Northern Trust points out. Sure, low mortgage rates make housing seem affordable, but mortgage rates will certainly rise back up to average historical levels. In April, the average mortgage rate was only 5.83%, compared with a 20-year average of 8.69% and 7.17% at the end of 1993.

And household balance sheets are hardly strong enough to take a drop in house prices. The equity that people have in their homes has plunged as a percentage of real estate assets since the mid-1980s. It is now 55%, compared with a 20-year average of 61%. Repayments on all types of household debt and leases are at a very high percentage of disposable income, and that means any increase in rates will bring down spending on goods and services. And even if individuals wanted to carry on borrowing, banks may be reluctant to extend credit at recent rates, since mortgage-related assets now account for 59% of banks' earning assets, a record high and massively up from around 30% in the mid-'80s.

The housing market takes time to drop when the credit spigot gets turned off. But the slide in house prices in certain areas will happen. This close link between debt growth and sales can be seen in the auto market. Even though automakers such as GM and Ford still grant incentives like 0% financing to consumers, they are having real problems hitting sales targets. What clearer sign could there be that people are maxed out and that auto prices are going to have to come down before cars sell?

As you can see, consumers are pretty well tapped out. I've been down this road before. When everyone's buying, you should be sitting tight, waiting for the nearly inevitable price correction.

That was Peter Eavis, commenting on TheStreet.com. This piece was Posted by MSN's MoneyCentral. This is certainly worth watching.