Thu, Jul 01, 2004 - Page 9 News List

Boom in house prices able to survive rate hike

By Robert Shiller

Interest rates around the world are poised to rise. Short-term rates have gone so low since the worldwide recession of 2001 -- 1 percent and 2 percent, respectively, in the United States and the Eurozone, and practically zero in Japan -- that a strengthening world economy will force central banks to tighten the monetary reins.

Australia's central bank has already been raising rates since May 2002, and Great Britain's since last November.

In the US, the two-day Federal Open Market Committee meeting on June on Tuesday and yesterday was believed likely to mark a major turning point, reversing the steady decline of the benchmark federal funds rate since Alan Greenspan began loosening monetary policy in 2001. This is likely to be followed by rate increases in China, the Eurozone, and elsewhere.

Given the tendency of central banks to change interest rates gradually, any change of direction likely means more changes in the same direction later. What will this landmark change mean for prices of such assets as stocks and homes?

In theory, when interest rates go up, there is reason to believe that asset prices will go down. The higher interest rates go, the better are investments in bonds, which compete with investments in other assets such as stocks or homes. Higher interest rates also raise the cost of borrowing to buy these assets, which may diminish demand for them, exerting downward pressure on their prices. When interest rates fall, the opposite effect on asset prices may be predicted.

In fact, the history of the stock market's reactions to changing interest rates is mixed. Sometimes interest rate changes have the predicted effect, sometimes they don't.

For example, the NASDAQ stock price index made a spectacular 14 percent jump upwards on the day (January 3, 2001) when America's Fed began its latest series of interest rate cuts. A jump in the market is what one might have expected. But then the NASDAQ index fell 22 percent over the following year, although the Fed continued to cut interest rates aggressively.

Does that experience suggest that the NASDAQ index will drop sharply if the Fed raises interest rates on June 30?

No. The timing of the 2001 rate decrease stunned the market. By contrast, the Fed has been widely expected to raise rates, so there will be no surprise element. The market may know, not just from the experience of 2001 to 2002, that interest rate movements do not have predictable effects on stock prices.

But, there are reasons to believe that higher interest rates, even though expected, can have a negative impact on home prices. That is because home buyers are mostly ordinary people with little financial sophistication, unlike the professionals who trade in stocks. Untrained people with other things on their minds can make serious economic errors.

Home values have soared to high levels in many countries as irrational exuberance grips the markets. High home prices are already putting great stress on many families, which are struggling to make their mortgage payments. When interest rates go up, these payments will (when the rate is variable) also go up, possibly becoming unsustainable.

If one borrows the equivalent of three years' income to buy a house, a mortgage rate of 6 percent means that 18 percent of one's income goes to interest payments, which may be tolerable. But if the rate rises to 8 percent, mortgage interest payments rise to 24 percent, which, together with amortization, taxes, other debts, and necessary expenditures, may claim too much of the family budget. Some will then try to sell their overpriced homes, and the resulting market imbalance will cause prices to fall.

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