By Martin Wolk
updated 6/30/2005 11:55:36 AM ET 2005-06-30T15:55:36

There is no doubt the housing market is a topic of increasing concern to Federal Reserve Chairman Alan Greenspan and other Fed policy-makers as they conclude their two-day midyear meeting Thursday. Analysts widely expect the central bank to raise short-term interest rates by a quarter-percentage point for the ninth time in a year.

Major Market Indices

In congressional testimony this month, Greenspan said he saw no national bubble but acknowledged “signs of froth in some local markets where home prices seem to have risen to unsustainable levels.”

Other Fed officials, including Gov. Susan Bies, have been warning in recent weeks that some lenders need to pay more attention to the quality of borrowers and housing projects they are financing.

But beyond such “jawboning,” it is far from clear exactly what the Fed can or should do.

The central bank has been raising short-term interest rates steadily since June 30, 2004, pushing the overnight federal funds rate from a historically low 1 percent to the current 3 percent. Thursday's expected move, on the the first anniversary of the tightening cycle, would raise it to 3.25 percent.

Yet such short-term rates have only limited impact on the housing market, which is driven more by interest rates on 15- and 30-year mortgages. Those long-term rates are set by global bond markets that are largely beyond the Fed’s control. And long-term rates have been moving steadily lower over the past year, even as short-term rates have moved higher.

The average 30-year mortgage, for example, is currently being booked at 5.57 percent, compared with 6.25 percent a year ago, according to mortgage giant Freddie Mac.

“Unfortunately the Fed’s tools on monetary policy are not very precise,” said Diane Swonk, chief economist for Mesirow Financial.  The Fed could raise short-term interest rates to 10 percent and “prick” the housing bubble, but that “would not necessarily be good for the rest of the economy, nor would it be prudent.”

“The reality of it is they cannot target one industry when they are shaping monetary policy,” she said. “They can have a limited effect on the macro economy and that’s what they try to do, but they cannot target asset price bubbles.”

She said the best way for the Fed to cool the housing market would be through regulatory action, ensuring that lenders impose higher thresholds before handing out loans that require no down payment and minimal monthly payments of interest only or less.

“I think they are going to be watching housing real close,” said Gary Thayer, chief economist for A.G. Edwards.

He said the Fed will hike rates next week and at least once more, bringing the benchmark lending rate to 3.5 percent.

“But beyond that I’m not sure that the Fed is going to keep going,” he said. “A lot depends on if oil retreats a bit or if housing cools off.”

Unlike some other analysts, Thayer is not worried about the potential spillover effect of a decline in housing activity.

“There is a risk that in really hot markets things could cool off,” Thayer said. “But I agree with Greenspan that it’s not likely to be a nationwide problem.”

But Ed Leamer, director of the UCLA Anderson business forecast, is more concerned.

Although he sees “virtually a zero chance” of recession over the next nine months, he said problems in the housing sector are building and ultimately could lead the U.S. economy into a new downturn.

“Each month that goes by with higher and higher levels of spending on homes, and higher and higher prices of existing homes, we are building a larger and larger mountain of adjustment-to-come,” he said in a report released this week.

In an interview, he said the economy is likely to soften in the second half of they ear due to declining investment in the housing sector.

“It doesn’t take much to take the wind out of housing,” he said. “We’re at the highest level ever of residential investment per worker over the age of 18. That’s just not a sustainable situation.”

The housing component of gross domestic product is likely to slowly decline, beginning later this year, he said. But the adjustment could happen more rapidly if interest rates rise sharply, fueled by inflation.

“When you’re in the midst of a bubble you just never know how long it’s going to last,” Leamer said. “We knew two years ago that there was a problem in housing … but we never said it was going to burst. As long as you have the support from the financial community with these incredibly low interest rates, then you’re not going to take a big hit on housing.”

Previously: Bubble or not, housing could spell trouble.

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