Interest Rate Forecast 2012-2013

The first half of the interest rate forecast is very simple: short-term interest rates will remain in microscopic territory through 2013. Less certain is the outlook for long-term interest rates, most likely a story of rising yields.

The forecast of low short-term rates is both the Federal Reserve’s announced intention and logical as well. (The two are not always the same.) The basis for the Fed’s plan is that the economy has a great deal of slack in it, and some of that slack will remain two years from now.

Critics of this view are worried about inflation. Jeffrey Lacker of the Federal Reserve Bank ofRichmond voted against the latest Fed decision on the grounds that inflation would rise and require an interest rate hike. That’s possible but, I think, highly unlikely. Historically, inflation has risen when money supply growth is excessive. One can point to the antecedents of money supply growth—increases in the monetary base—as evidence that inflation will accelerate. Currently, however, the connection between the monetary base and the money supply is not as tight as it used to be. Huge increases in the base have not led to large increases in money, because banks are holding on to excess reserves.  For inflation to accelerate, the money creation process must actually lead to increased spending. That hasn’t happened, and the forecasts of moderate economic growth indicate weak spending growth.

Skeptics may believe that the huge stimulus to the monetary base will eventually work its way into the money supply, and then to spending. That will eventually happen, but the current and near-future weakness of loan demand will delay that rebound. When the surge in money supply actually hits, then the Fed will have to raise interest rates. I believe they will but not in 2012 or 2013.  Maybe 2014 is the year.

Long-term interest rates are a different story, driven mostly by global credit demand, which in turn varies with the global economy. For dollar-denominated debt (such as United States Treasury bonds and mortgages), adjust world interest rates for changes in U.S. inflation.

The global economy is growing and should continue to do so, barring a European financial meltdown. Our inflation is unlikely to accelerate or decelerate, so changes in long-term interest rates will pretty much reflect world credit demand. I expect long rates to rise by about a percentage point a year for 2012 and 2013, which would leave the ten-year Treasury bond around four percent and the 30-year mortgage about 5.6 percent at the end of 2013.

Interest rate forecasts are not high precision numbers, and nobody should bet the farm on any forecast. The biggest fly circling the ointment is Europe and the potential for a financial meltdown. If that happens, look for the yields on high grade securities to fall as investors seek safe havens. At the same time that safe assets fall in yield, the interest rates on riskier bonds will rise sharply. Again, this pattern occurs only if Europe fails to muddle through its current crisis.

Business Issues:

From a business perspective, this is a good time to float long-term debt, probably the best time you’ll see for years and years to come. Short-term credit lines don’t need to be locked in, given the flat outlook for short-term rates.

Investor Issues:

This is an ugly time for fixed-income investors. My family recently reviewed our asset allocation. We’re light on bonds compared to the investable universe allocations. I really like be diversified, but I couldn’t bring myself to add more bonds in this low-yield environment. Maybe in a couple of years.

For those of you interested in what public policy should be given this economic outlook, check out my Businomics blog post, What Should the Government Do About the Economy.

Historical Perspective on Interest Rates

If you like history, check A History of Interest Rates.

Real Estate Forecast 2013: The Housing Market

The housing market will improve moderately in 2013, but nobody will mistake this for a boom. The gains in activity and prices will be a welcome relief, but will leave many homeowners still underwater.

The usual way of discussing housing problems is misleading. Foreclosures, short sales, shadow inventory, upside-down mortgages are all symptoms. The fundamental problem that we have is an excess supply of housing units.

The normal housing vacancy rate for owned property (single family houses and condos not in the rental market) is around 1.5 percent nationally. Our high was three percent, but we are now down to 2.1 percent.  Rental properties are normally about seven to eight percent vacant. (Local norms may be higher or lower.) We reached a peak of 11 percent rental vacancy a few years ago, but have improved to 8.6 percent in the latest observation.  Despite recent gains, we still have too many houses for the current level of demand.

(Data note: these data are a little soft. They do not exactly match vacancy information from other sources, such as the decennial census. They should be taken as a general magnitude, not high fidelity information.)

The improvement we’ve seen recently results from a simple phenomenon: construction of new fewer housing units has been less than the growth of demand. Last year total units (single family houses plus the number of apartment units) ran just over 600,000. This year we’ll probably build about 750,000 units. At the peak of construction in 2005 there were 2.5 million units built. We need about 1.5 million new units per year to accommodate population growth, the desire for vacation homes as well as demolition of old units. That, too, is a soft number. The true annual need may be 1.4 million or 1.6 million, but it was never 2.5 million nor 0.6 million.

Our recent underbuilding has been the greatest aid to housing recovery. It did not act as fast as we might have expected (as fast as I actually had expected), because the recession slowed population growth, from both a smaller birth rate as well as less net migration from abroad. In addition, the population we did have used fewer housing units per person, as adult children moved back in with their parents. Slow improvement in the job market means slow movement of kids away from their family homes, but even though slow, the movement is in the right direction.

It’s too early for housing starts to get back to normal—and we certainly will not see above-normal construction anytime soon. But 2013 will probably see over one million total housing starts. This will be a substantial percentage gain over 2012, but remember that a 30 percent gain from diddly squat is still not too far away from diddly squat.

Home prices will rise in 2013, but only modestly. The most recent data suggest that national average housing prices are rising by roughly five percent annual rate. That’s too optimistic a projection for the next few years, however, because there are many owners of multiple underwater properties who will sell as soon as they don’t have to lay out cash. That increased number of houses on the market will limit price hikes.

Business cycles aside, there is not much reason for housing price to appreciate by more than three percent plus inflation, or about five percent in this current environment. Periodic booms and busts will push price gains above or below trend, and a change in tax laws that favors or disfavors real estate will cause one-time price changes. Ten-percent appreciation expectations are fanciful on a long-run basis.

Businesses in the home construction supply-chain should prepare for a nice increase in sales volume in 2013, which will bring the usual boom-time challenges: finding good workers, ensuring an adequate supply of product from vendors, securing the working capital needed to grow production. (See my article on vendor performance and my video about working capital for growing businesses.)

Apartment investors (and landlords of single family homes and condos) will find that their little boom does not strengthen much further. Rents have risen so much that owning is becoming cheaper than renting in many cities. Add in the expectation of price appreciation and we’ll soon see renters itching to buy their own homes. Times will not be hard for landlords, but they should not project further gains beyond what they secured in 2012.

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