No Cut Without Risk

The Federal Reserve cut rates by 25 basis points, but will this stimulate the economy or create a another financial bubble?
September 23, 2019 Updated: September 23, 2019

The current economic climate is almost schizophrenic in its behavior and indicators, especially in the housing market. Normally, in a good growth environment with high employment there is no need to cut rates. That’s only necessary if the economy is slowing.

So why did the Fed cut rates last week?

Conflicting Data

On the one hand, with falling interest rates and sky-high housing prices, to some economists such as Robert Shiller, it looks like 2005-06 all over again. Shiller’s housing index, the S&P CoreLogic Case-Shiller index, tracks the values of the residential housing market in the top 20 regions. The index shows that as of June, housing sales have slowed for 15 consecutive months.

But Shiller’s assertion is by no means the last word on the subject. The latest report from the CoreLogic’s Home Price Index shows that new and existing home values—as opposed to transactions—have risen 3.5 percent year-over-year in July. Furthermore, in the wake of interest rate cuts, CoreLogic sees home prices and purchasing activity both rising through 2020.

This side of the coin seems more plausible because the economy is the strongest it has been in 50 years. With almost full employment, a record high stock market and rising wages, a good housing market is a logical outcome. The real problem is that wage earners are falling behind.

The response by the banking industry is predictable. With rising home prices well outpacing wages, new loan options for less qualified borrowers are once again supporting the housing market. Though lending standards still aren’t as lenient in the past, tapping the subprime market remains controversial. Not surprisingly, many experts are waving the red flag.

Economist David Rosenberg is certainly waving it, but for a different reason. While acknowledging there’s good news in the housing market, he notes that in the past six quarters there’s also been a pullback in residential construction and that it has “never performed so poorly for so long.”

And, according to the Mortgage Bankers Association, mortgage delinquency on rising. In the second quarter of 2019, late or missed mortgage payments rose across all loan types. Extreme weather is considered to be part of the reason for the delinquencies, but not all. The largest number of delinquencies are in the FHA and VA loan sectors, which is similar to the beginning of the mortgage meltdown in 2008.

The lesson here is simple: being able to buy a house is not the same as being able to afford a house. So one reason for the rate cut could be that the Fed wants to support the housing market.

Other Subprime Loans Emerging

The home mortgage industry isn’t the only lending sector to offer creative – or higher risk – financing. There are other lending sectors to consider that are related to the health of the economy. The fact that millions of Americans are behind on their car loans is one. Subprime loans to highly-leveraged companies is another.

In recent years, lenders in the United Kingdom, Australia, and the United States have issued their own version of subprime loans to companies carrying higher debt loads. That’s not inconsequential. Leveraged corporate debt is now larger and growing faster than the subprime market in 2006.

These facts allow for a different picture of the health of the economy. One question that remains open is whether or not a bubble in any of these debt markets could have the same effect as the housing market did in 2008.

A Weaker Business Climate from Trade War

At the same time, the Federal Reserve’s assessment of the economy is less than optimistic. The business investment in the United States is uncertain, and exports are falling. That’s to be expected, given that the trade war between the United States and China has deepened and is likely to continue.

That’s because there is little reason to expect a resolution of trade differences between Trump and Chinese president Xi Jinping will happen soon. Politically, Trump has painted himself into a corner and neither the democrats nor the republicans have an interest in cutting a deal before the 2020 election. Trump looks weak if he does, and the democrats want use the pain from the trade war as a political hammer against Trump heading into the election.

Furthermore, the effects of the trade war have only just begun to be felt in the U.S. economy. Subsidies have mitigated the initial impact in the farming and manufacturing sectors but it’s expected to get worse before it gets better.

The Fed’s Divisive Bubble Factory

In light of all this conflicting data, why are interest rates being cut when they’re already so low?

Past history tells us that when the Federal Reserve pursues a loose money policy, sooner or later, the prices of assets inflates. This mainly helps those Americans who already own assets such as real estate or stocks. Those who don’t are left behind. That’s a growing number of Americans.

For example, fewer people own homes today than in the past. Home ownership rates have decreased to 64.10 percent in the second quarter of 2019 from 64.20 in the first quarter. The long-term average is 65.22 percent. And only half of Americans are invested in the stock market; the other half aren’t benefitting from it at all.

Will slightly lower rates increase demand for U.S. products abroad? Will they enable more people to buy houses? Will they stimulate flagging business investment activity?

Lower interest rates are supposed to accomplish all those things, but is that realistic? It’s just as likely that they’ll produce asset bubbles.

James Gorrie is a writer and a speaker based in Southern California. He is the author of “The China Crisis.”

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

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