When Federal Reserve Chairman Benjamin Bernanke unexpectedly sliced the federal funds rate by half a percentage point on September 18, the stock market went on a tear, posting its largest one-day gain in five years. As of press time, the Dow JonesAverage was again flirting with the 14,000 mark and nearly 11 percent above the low of 12,517.94 it hit on the afternoon of August 16.
So, it would seem that the economy dodged a bullet. The drop in interest rates has helped ease credit markets that were locked down this summer in the wake of the sub-prime mortgage fiasco. In commercial real estate,volume is picking up again. And lenders have adjusted pricing, underwriting standards and required loan-to-value ratios.
Sure, things looked dicey for a while, but now it's up, up and away again, right? Perhaps not.
The fact that the Fed felt the need to act so dramatically and cut rates by so much after months of insisting that no rate cuts were forthcoming indicates that there may be real concerns about a recession.
Moreover, contrary to opinions from some pundits, the housing market is still far from turning around. The biggest indication that it's going to get worse before it gets better is the incredible volume of adjustable rate mortgages due to reset in the first six months of 2008. The reason this is important is that many of the loans that have been entering foreclosure — about 2 million before the end of 2007 — are ones where rates have reset from low teaser rates to much higher ones.
September marked the highest volume of loan resets so far this year — $58 billion. That's nothing compared to what will hit beginning in January. Then, $80 billion of loans will reset. The volume will peak at $110 billion in March. We will see more resets in the first six months of 2008 ($521 billion) than in all 2007 ($479 billion).
What does this have to do with the rate cut? On the up side, with lower interest rates, it's possible that when these loans reset, they won't jump as much. So we could see less foreclosures.
However, the rate cut brings a heavy downside.
The dollar index — based on a basket of foreign currencies — was already weak. Now it's fallen to an all-time low. For the first time since 1976, the American dollar and the Canadian dollar are at parity. The weakening dollar represents a threat because the U.S. has been borrowing heavily (about $60 billion a month) from other countries to fund the balance of payments deficit. The declining dollar makes these reserves worth less.
More troubling for thereal estate industry is that a weakening dollar increases the threat of inflation. And, it's coming at a time when Americans are facing rising energy and food costs — two things that aren't factored into the core inflation rate. On top of that, the use of home equity lines to fund consumption has disappeared. How much more can consumers take?
Consumer spending has been the lifeblood of not just retail real estate, but also two-thirds of the economy. By increasing the risk of inflation Bernanke may have traded short-term gains for Wall Street for long-term pain for everyone else.
We won't have to wait long to see how this will play out. The holiday shopping season is upon us. How retailers fare over the next three months will tell us a lot about what we can expect for 2008 and whether this summer's economic problems were a brief, painful blip or the start of an arduous restructuring.