The Goldilocks Puzzle: Did the Fed Get It "Just Right"?


By Ernie Ankrim, Ph.D., Chief Investment Strategist
Russell Investment Group

September 25, 2007

There's almost a fairy-tale quality to the American economy of late—a real sense of impending danger that, in the end, can and must be countered with patience and understanding.

In my last column on the August sell-off, I wrote about Chicken Little to say the sky is not falling. Now, following up on the Federal Reserve's interest rate cut of September 18, I've been thinking of Goldilocks who enters a cottage where three bears live. The bears' chairs are too big, too small and just right. Their porridge is too hot, too cold and just right. Even their beds are too large, too small and just right. This is where the tale of the Fed and the housing market comes in. And we'll need "just right" to create a happy ending.

You know part of the story. The housing industry has slumped. Subprime lenders have experiencing massive defaults. Sales have plunged although interest rates remain low compared to the 1970s, 1980s and some of the 90s.

Of course, easy credit enabled individuals to buy costlier houses than justified by their incomes or assets. Increased demand drove prices up. Then once-affordable mortgage payments were adjusted upward. Many homeowners found themselves unable to cope. Given high home prices, many buyers found themselves shut out of the market. Those home prices peaked then started declining.

Let me emphasize here that it's not bad that more individuals were able to buy homes. Mortgage products are not good or bad in themselves. It's how they're used. Those who used easy credit to speculate rather than purchase shelter appear to have made an exceptionally bad mistake.

Recognizing a peak and its aftermath

Stocks are simple to value. They're traded daily. Home prices are much more difficult to determine. Unless a fairly identical house sells near your own, you can't really put a finger on the price your home might bring. It's not marked to market. So when home prices peak then flatten, sellers are often the last to know.

What Happens After a Peak?

In October 1989, home prices peaked and held for a while. Then they plummeted. Six years later housing prices hadn't changed much. Historically, when a bubble bursts, home prices don't recover quickly.

In June 2006, rapidly rising home prices peaked again. Then prices started dropping, which they've continued to do in many regions. It's a distinct possibility that after we hit bottom—and I don't believe we're there—prices may stay flat for up to six years. But even after that, don't expect the go-go days of 2003-6 to return anytime soon.

What Does Today's Housing Peak Look Like?

Why does it take so long to recover? A large part of any run-up is speculation—the anticipation that home prices always go up and there will always be a big profit to be made. Of course, this is false as it is in the securities markets. It's safe to say that now most people will be more pessimistic for some time. Buyers won't jump at anything on the market. Sellers will have to lower their prices. It's like the bursting of the Tech bubble but without the dramatic sell-off.

Could home prices fall 30% to 40% over the next decade? It's possible—but only in terms of real housing prices adjusted for inflation. If you have a house worth $200,000, it probably won't be selling for as little as $120,000 five years from now. It might decline just a bit. But if you sell your $200,000 home for $180,000 in five years and figure in what inflation would have raised your price to, your 10% ($20,000) "loss" will be greater in real terms.

The Fed's September cut: just how timely?

When credit keeps tightening and people can't buy homes, builders don't build. And when the homebuilding industry suffers, our economy and the markets suffer. The Federal Reserve Board responded on September 18 by lowering the Fed Funds rate by half a point—probably a larger cut than many observers (including yours truly) imagined. The markets brightened. That day, the Russell 1000 shot up 2.89% and the Russell 2000 up 3.97%. The Dow Industrial index closed up 2.51% (336 points), the Nasdaq 100 up 2.71% and the S&P 500 up 2.92%. The next day, the markets rose again, although not nearly as much.

Interestingly, while the cut caused short-term interest rates to fall, ten- and thirty-year rates actually rose slightly. I attribute this to the markets' continuing fear that the Fed may be on the path of being too aggressive, which could impose a greater inflation threat down the road.

So, like Goldilocks, are we about to get out of the woods? Let's examine three scenarios.

Three Scenarios for Stocks, Bonds & the Dollar

When the Fed lowers rates and increases the money supply too late, the real economy is already on its way toward a recession. When the Fed is too early and/or aggressive in its rate cuts the real economy picks up steam but the inflation rate rises. When the Fed gets it just right, the real economy continues to slow for a while, but it doesn't go into recession and inflation stays under control.

Given the 50 basis-point cut on September 18, I believe the Fed was not too late. This action has substantially reduced the probability of a recession, which would be very bad for stocks, very good for bonds and very good for the dollar.

So is the Fed too early or just right? I do believe that the September 18 cut was bigger than needed to help the economy deal with the subprime credit problem without spurring inflation. We'll know more by the end of autumn. If the Fed cuts another quarter-point in October then leaves the Fed Funds rate alone for the remainder of 2007, the total three-quarters of a point cut will be about what I expected. (However, I did think that the Fed would reach that mark by cutting a quarter point each meeting for the rest of the year.)

Some people say this cut isn't nearly enough. They want another half-point cut in October and perhaps another quarter—point reduction—or even a half-point-in before the New Year. If the Fed does that, I believe they will be adding too much liquidity to the market -- anticipating a sharper downturn in the economy than I believe was on the way. Short-term, a total September-December cut of one point or more would be good for stocks. It might be good for bonds. But long term, cutting rates too dramatically would set the stage for higher rates of inflation—which would be bad for stocks, bad for bonds and very bad for the dollar.

Good reasons to hold onto your portfolio

I'd be surprised if the Fed strays so aggressively from its long-time stated goal of inflation control. So I believe there's an infinitesimally small possibility of the Fed being too late, a higher probability of its being too early, and an even greater probability of getting it just right (assuming we have no more extended/dramatic rate cuts in our future).

Regarding housing: many lenders have bailed out of the subprime business so help from any Fed actions will be slow in coming. When they do, they'll affect conventional mortgages, whose rates ironically are now higher than before the September cut.

As for the markets: if the Fed cools itself down a bit, the economy could work itself out just right. We'd see strong stock returns and fairly flat bond returns, which is about where we are now. We could see a more stable dollar, too, if the rest of the world, facing an economic slowdown, stops increasing interest rates. Europe's central bank and the Bank of England have shown a willingness to do this.

Predicting the economy's future, including home prices, is difficult. Some of our best minds have gotten this wrong. Alan Greenspan, former Fed Chairman, told Reuters on October 26, 2006, "Most of the negatives in housing are behind us. The fourth quarter should be reasonably good, certainly better than the third quarter." Yet on September 20 of this year, he remarked in Vienna, "Prices are going to fall much lower yet." Mr. Greenspan's remarks represent a 180-degree turn. I have no doubt that many surprises still lie ahead for us all.

What makes sense for investors? We should get back to thinking of our homes as places to live, rather than the key to our future returns. Stay committed to your strategic portfolio of financial assets. They still can be the greatest source of financial security. Plan for the long term, and you'll be behaving the right way—just like that little blonde-haired girl who encountered bears, as investors often do, but returned home safe and sound.

The S&P/Case-Shiller® Home Price Indices measures the residential housing market, tracking changes in the value of the residential real estate market in 20 metropolitan region across the United States.

These views are subject to change at any time based upon market or other conditions and are current As of September 25, 2007. The opinions expressed in this material are not necessarily those held by Russell Investment Group, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

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