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Pedal to the Floor: But Will It Be Enough?

The government is going all out to break the downward slide of the U.S. economy and propel it uphill. Three metrics will help determine whether these efforts will succeed and, if so, how soon: (1) the fiscal stimulus, measured by the level of the federal deficit; (2) the monetary stimulus, measured by the growth in the money supply; and (3) the housing stimulus, measured by the interest rate on 30 year fixed rate mortgages.

The Obama administration has estimated that this year's federal deficit will be $1.75 trillion or 12.3% of Gross Domestic Product (GDP) in order to pay for the steps being taken to assure an economic recovery. Most economists believe that this projection is too conservative and is based on unrealistic assumptions about growth in the last three quarters of this year. They estimate the deficit for fiscal 2009 is more likely to be in the neighborhood of $2 trillion, which would be 14% to 15% of the GDP. That would be more than four times as great as the prior record deficit of $482 billion in 2008, the last year of the Bush administration. Even if the deficit were to come in at 12.3% of GDP, measured as a percent of GDP that would be the largest deficit since World War II.

Seemingly, a budget deficit of this magnitude should do the trick, but on closer examination there is less here than meets the eye. The $750 billion expenditure of TARP relief is primarily aimed at saving financial institutions, auto companies and others from collapse and only secondarily stimulating growth. There has been a substantial amount of misunderstanding and confusion about this. The primary aim of federal loans and investments in banks was to save them from collapse, not to get them lending more. The rationale that the federal expenditures would assure additional lending was in significant part offered up to appease the demands of Senators and Representatives. In fact, the two goals are to some degree inconsistent. Making imprudent loans was one cause for the losses suffered by financial institutions. If they are now pressured to make a new batch of imprudent loans, future failures or problems will likely result.

The money supply is also growing at the fastest rate since World War II. The broad money supply (M2) is increasing at an annual rate of nearly 15% over the past six months. Growth in the money supply as the result of actions taken by the Federal Reserve in and of itself is not enough. To assure sustained growth, that money supply must achieve velocity by increased lending and borrowing. For more than a year banks have been tightening lending requirement for a broad range of loans - homeowners' and commercial property mortgages, credit cards, small businesses, etc. The lending restrictions are the result of significantly increased default rates and concern that borrowers will be unable to repay in a faltering economy. As lenders have tightened their lending standards, prospective borrowers have sought fewer loans. The store owner whose business is faltering is far less likely to open a new location or expand inventory. While it may be politically fashionable to blame the banks for reduced lending, the vicious cycle is due to understandable caution by both lenders and prospective borrowers.

Pumping up the money supply will only work if lenders and borrowers are confident that the economy will grow. The excessive extension of credit during the last up cycle has brought in its wake high levels of default which now restrict lending growth.

The rate on 30 year fixed rate mortgages has dropped to approximately 4.85%. That is the lowest level since 1956 - 53 years ago. The low rate has been brought about by a variety of actions taken by the Federal Reserve: (1) the effective federal funds rate is approximate 0.15% (15 basis points) - essentially zero - as the Fed has gone all out to grow the money supply; (2) recently, the Fed took the unprecedented step of buying long term treasuries to bring down long term rates; and finally (3) the Fed has taken another unprecedented step by directly purchasing mortgage backed securities as part of the TARP program.

The lowest 30 year fixed rate in over 50 years, while remarkable, must also be placed in perspective. It is only about 1% below the 30 year fixed rates for the three years of housing boom, 2003 thru 2005. According to Freddie Mac, 30 year rates ranged from 5.83% for 2003 up to 5.87% for 2005. During this period the majority of borrowers were not even using 30 year fixed rate loans. They were borrowing with 1, 3 and 5 years fixed then adjustable loans which provided even lower rates. The availability of these adjustable loans has become vastly restricted as a result of the housing collapse and, when available, the differential in the rate offered has been negligible. The net effect of all this is that while the drop in the 30 year rate increases housing affordability, thereby supporting sales and prices, there will be less benefit from the drop in the 30 year rate than in past cycles.

By lowering the 30 year home loan rate, the Fed is seeking both to prop up the housing market and to permit homeowners to refinance at lower rates. By refinancing and lowering monthly payments, the Fed hopes that home owners will spend the savings and thereby stimulate the economy.

For both the prospective home buyers and home owners who wish to refinance, the drop in the 30 year rate may be insufficient. Home owners may no longer have sufficient equity in their homes to refinance or may no longer qualify due to a drop in income as a result of the recession. For the home buyer, the no down or 10% down days for conventional loans are history. The undocumented loan has been replaced by far more careful scrutiny of the borrowers' income flow and credit obligations. The government is taking a variety of steps in addition to driving down rates to assist buyers and refinancers. An $8,000 tax credit has been enacted for first time buyers. Conforming loan limits will soon be increased, which will help owners and buyers in high cost areas.

The biggest budget deficit as a percent of GDP since World War II, the fastest growth in the money supply since World War II, the lowest 30 year fixed rate mortgages in more than a half century - these are major steps that should not be underestimated. At the same time, they should not be taken as a sure remedy. By placing them in proper context, the investor will have a better picture the likelihood and rate of recovery.


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