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msnbc.com
updated 6/9/2005 6:01:00 PM ET 2005-06-09T22:01:00
ANALYSIS

Federal Reserve Chairman Alan Greenspan left little doubt Thursday that the central bank intends to continue pushing short-term rates higher. One major reason could be that Greenspan wants to do everything within his power to remove what he calls “froth” from some of the nation’s booming housing markets.

Major Market Indices

In testimony before a joint House-Senate committee Thursday, Greenspan reiterated that he is puzzled by the decline in long-term interest rates, which has seen rates for traditional 30-year mortgages slide to their lowest levels in more than a year . Such low mortgage rates are buoying the housing market, sending home prices surging at a 12 percent annual rate, according to one recent government report.

Greenspan and the Fed have little control over these fixed mortgage rates, which are pegged to movements in the massive global bond market. But the Fed does have a powerful influence over one important segment of mortgage rates through its control of short-term bank lending rates.

“The only part of the mortgage market that the Fed has control over is adjustables,” said Vince Boberski, senior economist at RBC Dain Rauscher.

Adjustable-rate mortgages, including what Greenspan called “relatively exotic” financial instruments such as interest-only and no-money-down loans, have been one of the major factors in sustaining high home prices in California and other coastal markets.

By continuing to raise short-term rates, the Fed can reduce the differential between such relatively risky loans and higher-quality, fixed-rate mortgages, Boberski said.

“It’s a way for them to let some air out of the housing market,” Boberski said.

In his opening statement to the panel, Greenspan did suggest that the Fed is concerned about home price inflation, citing the “dramatic” increase in the use of risky mortgages.

“To be sure, these financing vehicles have their appropriate uses,” he said. “But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.”

He added, however, that any bubble-bursting likely would have only local impact and would not harm the national economy.

The Fed has other reasons for wanting to raise rates besides cooling the housing market. With the economy on “reasonably firm footing,” as Greenspan put it, the Fed can continue to remove the stimulus of low short-term interest rates.

In response to a question in the congressional hearing, Greenspan indicated the Fed still has ground to cover to get to its desired “neutral” level of rates, which would neither restrain growth nor contribute to higher inflation.

“It’s very difficult to know where that so-called neutral rate is, but we will probably know it when we are there, because we will observe a certain degree of balance which we have not perceived before...,” Greenspan said.

Greenspan's remarks appeared to override a comment by Dallas Fed President Richard Fisher, who said last week that the Fed was in the "eighth inning" of its rate-hike cycle.

The Fed is seen as certain to raise short-term rates a quarter-percentage point at its next policy-meeting, which concludes June 30. That would bring the overnight lending rate to  3.25 percent, compared with 1 percent when the Fed began hiking rates a year ago.

Most analysts expect the Fed to hike rates at least once more and possibly three more times this year, which would bring the rate to 4 percent by the end of the year as Greenspan prepares to step down early in 2006.

That is almost exactly the current yield on the 10-year Treasury bond, which has fallen from 4.9 percent over the past year as the Fed has raised short-term rates. Such a “flat” or inverted yield curve generally suggests that bond traders expect a sharp economic slowdown or recession.

Greenspan noted that decline in long-term rates is the fastest seen in recent decades. “So something unusual is clearly at play here,” he said in response to a question.

But he said the decline did not “necessarily” signal an imminent economic slowdown as it might have in the past.

Some analysts disagree, saying the bond market is raising a red warning flag.

“Greenspan seems to have a blind spot when it comes to flattening yield curves,” said Paul Kasriel, economic research director at Northern Trust Co. He said the bond market sent similar signals prior to the 1990-91 and 2001 recessions. Both times Greenspan ignored the warning and continued pushing short-term rates higher.

Kasriel agrees that Greenspan would not mind cooling the housing market a bit, but not at the risk of causing a recession.

“I don’t think he wants to be remembered as the guy who created the housing bubble and then burst it,” Kasriel said. “If he’s getting an indication in August that this thing is slowing down and it’s not just a temporary soft patch, I don’t think he’s going to keep raising rates just to burst the housing market.”

Kasriel predicts the June 30 rate hike will be the final one of the current rate-hike cycle, a distinctly minority view among financial market economists and traders.

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