May 10 FOMC Minutes - Open Mouth or Open Market Policy?
On balance, the May 10 FOMC minutes read more hawkish than Bernanke's JEC testimony and perhaps even the May 10 policy announcement. There was the typical on-the-one-hand but on-the-other-hand rhetoric. But the hand presented first was that inflation and, importantly, inflation expectations were higher than expected. For the first time in a long time, the potential inflationary implications of a falling dollar were mentioned. As I said, almost every concern about higher inflation was matched with a reason not to be concerned. But the concern was mentioned first. Moreover, there was relatively little concern about the downside risks to economic growth. Heck, at least one FOMC member wanted to raise the funds rate by 50 basis points at the May meeting!
How much of this was bluster to demonstrate the new Fed chairman's bona fides with regard to price stability or how much was the true sentiment of the FOMC will presumably become clear on June 29. The traders in the fixed income markets seem to believe that it is the true sentiment as evidenced by the July fed funds futures contract selling off 3 basis points after the release of the May 10 minutes today and the 2-year Treasury yield rising almost 4 basis points in post-minutes trading. Since May 10, the TIPS break-even spread, a measure of inflation expectations, is only marginally narrower and the year-over-year percent change in the core PCE price index has breached the presumed 2% upper boundary of the FOMC's zone of tolerance.
Even without a move to 5-1/4% on the funds rate, I had thought that the FOMC would be cutting interest rates by year-end. If, as now seems likely, the FOMC is going to push the funds rate up to 5-1/4% on June 29, I am even more confident of rate cut later in the year. As discussed below, housing is slipping into a sinkhole. Wal-Mart reported that its May sales were on the softer side of Sears, so to speak. This was reinforced by the 4-week average of the ICSC - UBS Warburg chain store sales index being below the April average. May motor vehicle sales are expected to have come in below April's. All of this adds up to annualized growth in Q2 real PCE expenditures of less than 2% vs. 5.2% in Q1. The Republicans had better not be pinning their hopes on a strong economy to maintain their control in Congress come November, especially if the FOMC hikes the funds rate to 5-1/4% on June 29.
April Housing Affordability Lowest Since July 1990
The National Association of Realtors released its monthly housing affordability index today. The April reading dropped 3.3 points from March to a level of 108.6 - the lowest since July 1990. Although rising interest rates have played a role in recent months making housing less affordable, but it certainly is not the level of interest rates that has brought the April affordability index down to 1990 levels. In April 2006, the commitment rate on a 30-year fixed mortgage was 6.51%; in July 1990, the commitment rate was 10.04%. In April 2006, the median price of an existing single-family home was 5.9 times the median family income; in 1990, it was 2.7 times the median family income. So, the run-up in real estate values relative to income to record highs is the driving force behind the sharp decline in housing affordability. Interest rates are unlikely to plunge in the near term. So, either median family incomes have to rise rapidly or housing prices have to fall rapidly to make housing more affordable again. Although I am not predicting a rapid fall in home prices, I do believe that there is a better chance that home prices will be the factor improving the affordability of housing in the next couple of years rather than rising median family incomes.