NAHB Interest Rate Concerns Arise in Bernanke Testimony

Recent warnings by National Association of Home Builders that the Federal Reserve runs the risk of turning the cooling process now underway in the nation’s housing market into a full-fledged downturn if it continues to push up interest rates resounded in congressional testimony last week by Fed Chairman Ben Bernanke.

When confronted in the Senate on July 19 with evidence of falling housing starts and permits, including the sizeable declines reported by the Commerce Department that morning for the month of June, Bernanke noted significant uncertainties and risks in the housing outlook and stressed that the Federal Reserve is watching housing “very carefully.” He repeated these points the following day under questioning in the House.

On a significant housing-related issue of a more technical nature, Chairman Bernanke acknowledged NAHB’s concern that the Fed’s inflation-fighting efforts are having a perverse impact on the government measures of core consumer price inflation that are being used to guide its policies. In written testimony, he agreed with association economists that “increases in residential rents, as well as in the imputed rent on owner-occupied homes” have contributed to higher core consumer price inflation.

In a July 18 letter advising members of Congress of the impact of rising interest rates on housing, NAHB said that the Fed has been relying on “deficient inflation measures to rationalize the interest rate hikes that have been taking a serious toll on the housing sector. Ironically, much of the recent increase in ‘core’ consumer price inflation that the Federal Reserve is trying to control with higher interest rates is coming from a weakening housing market.”

Under questioning during the Senate and House hearings, Bernanke agreed that the large imputed “owners’ equivalent rent” component of the core Consumer Price Index was being pushed up because of the weakening of home buying and the related firming-up of market rents. In this regard, he also conceded that tighter monetary policy can actually put upward pressure on core inflation through the imputed “owners’ equivalent rent” mechanism, possibly creating a self-defeating cycle of monetary policy tightening and accelerating core inflation.

Referencing the association’s letter, Senate Banking Committee Ranking Member Paul Sarbanes (D-Md.) said that “NAHB makes a rather valid point in communicating with us about this measure” and the Fed being caught in a “vicious cycle” of raising interest rates in response to a “technical measure” that doesn’t really indicate what home owners are actually paying.

During his appearance the next day before the House Financial Services Committee, Bernanke was closely questioned by Rep. Gary Miller (R-Calif.) about the effect of rising interest rates on housing costs. He cautioned Bernanke that “every time you raise interest rates, you price buyers out of the market,” and again pressed him on the “equivalent rent” issue.

In its letter to Congress prior to Bernanke’s appearance, NAHB cited growing evidence that the moderate and orderly housing downswing described by the Fed Chairman could evolve into something far worse if interest rates continue to be raised.

“NAHB’s recent surveys of home builders show a serious downtrend in housing demand, due largely to the series of interest rate hikes already enacted by the Federal Reserve,” the letter said. “and builders’ expectations for future home sales are weakening considerably as well.”

Among the downside risks for the housing market, NAHB warned, are the deepening of affordability problems for prospective home buyers and the potential for a quick surge in builder inventories if investors and speculators in single-family and condominium markets in many areas of the country decide to flee the market by cancelling their sales contracts.

The exchange between Bernanke and members of the Senate on both the downside risks to housing and the effect of “owners’ equivalent rent” on the core inflation measures presumably contributed to the soothing effect of the testimony on the financial markets, according to NAHB Chief Economist David Seiders.

“Recognition of the downside risks to home sales and housing production reduced the markets’ estimates of the probability of more Fed tightening,” said Seiders. “And the markets now know that the Fed at least partially discounts the increases in the ‘owners’ equivalent rent’ component that recently helped drive both the core CPI and the core Personal Consumption Expenditures price index above the upper ends of the Fed’s apparent comfort zones for these measures.”