By Martin Wolk
updated 6/24/2005 5:01:31 PM ET 2005-06-24T21:01:31

Surging oil prices helped drive the stock market sharply lower this week, rapidly undoing a rally that had been gaining momentum over the past several weeks. But while $60-a-barrel oil raises the specter of both slower growth and higher inflation, in the short term higher energy prices could buoy the red-hot housing market, which shows few signs of cooling.

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Persistently higher oil prices cut two ways into the economy — generating inflation pressures but also acting as a virtual tax that slows consumer spending and therefore saps growth. Economists — and bond market investors — generally feel that the negative impact on growth from higher oil prices outweigh the potential inflationary impact.

In the reverse logic of the bond market, slowing growth means higher prices and lower yields and contributing to what Federal Reserve Chairman Alan Greenspan has memorably labeled the “conundrum” of low long-term interest rates.

That is where the housing market fits in. As long as the bond market keeps long-term interest rates low — including mortgage rates — the housing market has been responding with sales, prices and construction activity that have consistently outpaced even optimistic forecasts.

Data on sales of new and existing homes reported this week showed that activity slowed slightly in May from the record pace seen in April. But even economists who say housing prices are at overinflated “bubble” levels are hard-pressed to find evidence of a slowdown.

“This is a market that has gone from white-hot to red-hot,” said Christopher Thornberg, an economist UCLA’s Anderson business school. “At some point in time this has to end, but trying to figure out exactly when is difficult for obvious reasons. A bubble market by definition is irrational and tough to call.”

More evidence of economic slowing — helping to keep a lid on long-term rates — came Friday in the government’s monthly report on orders for long-lasting durable goods .  Even though orders rose at the fastest pace in 14 months, several analysts pointed out the spike was mostly due to a surge in orders for Boeing Co. aircraft.

That is good news for America’s biggest exporter, to be sure, but economists routinely focus on orders for non-defense capital goods excluding aircraft to get a gauge on underlying business spending intentions. And there the picture is not so bright.

These core orders fell 2.3 percent last month and have dropped in three of the past four months, supporting the view that businesses are cutting back on capital spending as they see a slowdown in profit growth, said David Rosenberg, chief North American economist for Merrill Lynch. That business-unfriendly cycle of slowing profits and investment is yet another reason for gloom on Wall Street.

It is against this backdrop that Greenspan and other Fed policy-makers meet next week for their annual midyear discussion of economic developments Wednesday and Thursday. It is considered virtually a certain bet that the Fed will raise the overnight lending rate by a quarter-percentage point for the ninth time in a year, bringing the benchmark to 3.25 percent.

But while Fed officials have begun voicing growing concern with what several have termed “froth” in the housing market,  by now it must be growing apparent to them that raising short-term rates by a quarter-point at a time is not going to have much impact on housing activity, which is being driven more by the easy availability of cheap long-term credit.

To have any impact at all, the Fed and other banking regulators are going to have to be much more aggressive in exercising “moral suasion,” perhaps by issuing guidelines that would limit the overuse of novel lending products like interest-only loans that have been fueling the housing boom, said John Silvia, chief economist at Wachovia Securities.

In the meantime, it appears the bond market will continue to fight the Fed by providing lower long-term interest rates than almost anyone would have predicted six months or a year ago. And higher oil prices will help fuel the fire, at least for now.

“In the short run higher oil prices — to the extent that lower perceived inflation risks — actually are a positive for housing,” Silvia said. “In the long run, if oil really does weaken the economy, then it’s negative for housing.”

And if persistently higher energy prices translate into a surge in consumer inflation, 30-year mortgage rates could rise in a hurry, putting a chill into the housing market.

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