Is The Fed Making The Same Low-Rate Mistakes?

By: Chris Ciovacco | Tue, May 20, 2014
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2014: Seeing Some Bubble-Like Comments

The segments below from a recent CNN Money article have a familiar 2002-2006 housing bubble ring to them:

The competition for the homes that are available is so intense that buyers need to bring plenty of cash to the table. In fact, all-cash deals hit a record 43% of home sales in the first quarter of this year, according to RealtyTrac...Demand is so high that real estate agents are actively seeking people who are willing to sell. "You get letters in the mail asking if you're interested in selling," said Jackson. "People knock on your doors."

Setting The Debate Table

Prior to considering the basic question of is the Fed making the same "keeping rates too low for too long" mistake, it is important to set the table from a historical perspective. The slope of the home price curve below began to steepen in 2003 before cresting in late 2006.

Home Prices

Since interest rates impact affordability, they also impact demand for housing. If you think in extreme terms, if mortgage rates were currently sitting at 10%, how many first time home buyers would be able to even consider home ownership? The graph of interest rates below shows an extended period during which Fed policy was very helpful to the housing industry.

Low Interest Rates

Many Factors Contributed To The Housing Bubble

Regular readers know we believe that our firm's opinion has very little impact on asset prices, a concept that was described in detail under the What Determines The Value Of Our Investments? subheading in a May 14 article. What does matter is the general investing public's opinion; something we can gauge from the readers of this article. Therefore, the purpose of this article is not to make a case on the "low rates too long" question, but rather to spark a debate among readers. The excerpts below relate to the original 2002-2006 housing bubble and may help readers tap back into their housing bubble memories, perspectives, and experiences. From the Economists View by Mark Thoma, Professor of Economics, University of Oregon:

I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor-far from it-but it does appear to be one of the more important ones. Here is my list of reasons why:

  1. The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.
  2. Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way-via financial innovation, lax governance (both private and public), and misaligned incentives-into the housing market.
  3. Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s.

Fed Policy: 2002-2006 vs. 2009-2014

If we assume low interest rates played a role in the 2002-2006 housing bubble, a fair question is:

How does recent Fed policy compare to the 2002-2006 period?

The answer is provided via the graph below. If the orange box contributed to the housing bubble, then at a minimum it is reasonable to ask if the Fed making the same mistakes again?

Effective Federal Funds Rate

Housing Prices Are Rising Again

We opened the article with 2014 anecdotal stories of "intense" competition for homes. Nationally, as shown in the graph below, prices are rising at a fairly steep rate (again).

Home Prices

Fed Policy Aligns With Economy

Is it fair to compare Fed policy in 2004 head-to-head with policy in 2014? No it is not fair; the economic landscape is a part of Fed policy. However, the graphs of interest rates above do sound some alarm bells from the potential "bubble blowing" perspective.

Respecting The Law Of Supply And Demand

Before we open the debate on how Fed policy impacted the inflating of the housing bubble and its current impact on housing prices, it is important to respect that prices are governed by both supply and demand. According to Investopedia:

The law of supply and demand defines the effect that the availability of a particular product and the desire (or demand) for that product has on price. Generally, if there is a low supply and a high demand, the price will be high. In contrast, the greater the supply and the lower the demand, the lower the price will be.

Supply Has Been Impacted By Fed

If we keep simple economics in the picture, the low supply of homes in 2014 bubble-like areas, such as Boston, cannot be ignored. However, low supply is due in part to the post-bubble world. Imagine if a homebuilder approached a bank in 2010 and said:

"I want to begin development on hundreds of new homes in the greater Boston area to meet what we believe will be a supply shortage in the years ahead."

That developer would have been kindly told by potential creditors:

"We are not interested in lending to anyone for the development of single family homes. We wish you nothing but success in terms of finding credit."

When markets get skewed as housing did between 2002 and 2006, it alters the pricing mechanism from both a supply and demand perspective.

Investment Implications - Not Much Has Changed, But...

Do low interest rates and the potential for new asset bubbles impact our approach to the stock market? Yes, if stock prices have been inflated in part due to the Fed's asset-friendly policies, then it means the market has a higher than normal speculative bent to it. Downside risks are higher in speculative markets, meaning it is important to have specific capital preservation plans in place, with an emphasis on specific.

Staying with the specific theme, having something firm to manage against is always a good idea, but even more so in an indecisive market environment (see last five months). The tactical tweets below speak to an ongoing trading range, and the need to have defensive contingency plans within reach ($SPX is the S&P 500 Index):

Ciovacco Tweets

We will enter Wednesday's session ready to play defense. The S&P is down 5 points so far this week. Since not much has changed (yet), we continue to hold a mix of stocks (SPY) and bonds (TLT). Let the debate on housing and the Fed begin.



Chris Ciovacco

Author: Chris Ciovacco

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at

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