Is The Housing Recovery Just an Illusion Created by the Federal Reserve?

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It’s now conventional wisdom that the housing market — once the anchor that sank the American economy — is the ballast that’s keeping it afloat, however tenuously. The Case-Schiller index of home prices, released last week, showed a sixth straight month of year-over-year increases. Rising home prices buttress consumer demand as home prices are the single biggest source of the average consumer’s wealth. In addition, a recent report on housing starts showed that more new buildings are being constructed than at any point since July of 2008, and a revitalized construction industry could do much to bring down unemployment and spur economic activity.

Jed Kolko, the Chief Economist for the real estate website Trulia, compiles a “housing barometer” that measures how close the real estate market is back to normal based on housing starts, existing-home sales, and delinquency and foreclosure statistics. His most recent reading put the housing market at 47% back to normal. Writes Kolko:

“In the past three months, Trulia’s Housing Barometer has risen from 34 percent to 47 percent, which is the largest quarterly increase since we started tracking the recovery 18 months ago. Not only is the housing market closer to normal than at any other point since the crisis, the recovery is also accelerating.”

(MORE: Why Are Real-Estate Listing Sites Hot Right Now?)

In other words, there’s plenty of data to choose from for a housing market bull to make his case. But even if these data clearly show an incipient recovery, what exactly is the reason for it? Tim Iacano of Iacano Research believes that most — if not all — of the recent rise in home prices is a direct result of efforts by the Federal Reserve to stimulate the economy.

The Federal Reserve has kept short term interest rates at near-zero since 2008. In order to stimulate the economy further, the central bank has engaged in quantitative easing (QE) or the purchase of U.S. treasury bonds and mortgage debt in order to drive down long-term interest rates as well. The most recent round of QE was specifically aimed at mortgage-backed securites (MBS), and was effective at lowering mortgage rates to all-time lows.

One of the main ways this sort of action helps stimulate the economy is by increasing home values, for the reason that if you lower the interest rate you need to pay in order to finance the purchase of a particular asset, you raise the price at which a home buyer can afford to purchase it. As Iacano points out, lower home mortgage interest rates can mean dramatically higher home prices. Iacano notes that with today’s record-low rates of 3.3%, an $1,100 per month mortgage payment can finance a house worth $280,000. He continues:

“Even if mortgage rates moved back up to their 20-year average rate of 6.5 percent (what many thought were  simply unbelievable rates when they first dropped that low last decade), that same $1,100 mortgage payment would finance a home purchase of just $193,000, not the current $279,000. The difference between these two prices is nearly 50 percent!”

(MORE: Home Prices Rise Across the Country in September)

Iacano admits that the Federal Reserve isn’t solely responsible for what he calls “freakishly” low mortgage rates. Any time an economy is depressed to the extent ours is, interest rates are going to fall. But given the Fed’s aggressive action to drive down rates, we can safely assume that they are primarily responsible.

Of course, one might counter that boosting the economy by boosting home prices is exactly what the Fed had set out to do. And our economy is undoubtedly better off by being in a situation where home prices are rising rather than falling. But this analysis does beg the question: What happens when the Fed tries to extricate itself from quantitative easing? How will homeowners react when — because of the Fed’s selling of MBS — their home values plummet? That will be a politically tricky task, regardless of how committed Ben Bernanke, or whoever the Fed chair happens to be at the time, is to it. In addition, while the housing market is recovering, any measure of its health like housing starts still will show a very depressed market by historical standards. We still have a long way to go. When can the Fed safely start to sell off its assets, and how will it time this move correctly?

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This is not to argue against quantitative easing. The risks of a highly depressed economy, and the type of human suffering that is the result of it, arguably outweigh whatever negative side effects aggressive central bank policy create. (And I generally agree with that argument.) But if the main bright spot in our economy is so dependent on the Federal Reserve, we should be wary of getting too giddy about a recovering housing market, and be aware that reversing central bank influence once the economy recovers may be more difficult than the Fed claims it will be.

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