If you buy into this — and I think Bernanke does — my theory makes sense.
Low real rates drive fixed income asset prices higher; therefore, when prices stagnate you buy more debt to induce price inflation. Which is, of course, exactly what Bernanke’s doing via Operation Twist and his QE programs.
The problem is eventually the prices of the assets being purchased rise to levels that result in a negative yield to maturity. This means that buyers paying the inflated prices will lose money as maturity approaches because fixed-income yields rise at the same time.
Yet, the Fed buys anyway and so do many institutions. They do so because they are concerned with matching their liabilities so the losses they incur along the way are acceptable.
Individuals obviously don’t have this luxury. They don’t care about matching liabilities like the Fed does. Rather, they care about not having liabilities in the first place, especially when they are tied to assets that could decline over time, like their houses.
But don’t houses always rise in price over time?
I know that’s the conventionally held wisdom, which is why Bernanke may believe it, but the data suggests otherwise. Low interest rates don’t translate into higher housing prices. If anything, they move in reverse.
The Economist highlighted this dramatically in an article last April noting that while real interest rates have plunged to their lowest levels in the last quarter century, “this hasn’t helped the housing market at all.”
In fact, noted the article’s author, Buttonwood, if you divide the last 24 years of U.S. housing price data into thirds, average housing gains were 32% higher when rates were higher and rising than when they were lower and falling.
Figure 1: Economist.com
Naturally, there are those who dismiss this data, suggesting it somehow doesn’t reflect the bigger picture.
They’re right — it doesn’t. The bigger picture is even more damning.
Over time, housing prices barely keep pace with inflation and even then for shorter periods only. This means they are not a proxy for personal savings, nor can they possibly contribute to long-term economic stability or even short-term growth.
What the Case-Shiller Index Really Says About Housing
You can see that very clearly in the Case-Shiller Index created by Yale economist Robert Shiller.
Dating all the way back to 1890, the Case-Shiller Index reflects the sale prices of existing houses rather than those of new construction so as to more cleanly track housing values as investments over time.
Using a base of 100, the index suggests that the value of a $100,000 home (adjusted for inflation in today’s dollars) purchased in 1890 would sell for only $119,000 today, 122 years later. That’s a mere 0.15% a year appreciation using simple math.
Worse, the data also suggests that prices have yet to fully revert to their average, which is 112.9263, versus the most recent index reading of 119.9263.
Put another way, existing home values have to fall another 6% before our nation comes into line with historical averages.
Figure 2: Source: Robert Shiller, Yale University
The other thing that’s apparent if you look at Shiller’s data is that housing prices return to their mean over time irrespective of changes in both building costs and population – both of which are frequently cited as key real estate investment drivers.
No doubt I am going to catch lots of flak for this from real estate professionals. I hear you guys…but hear me. I am not saying real estate is always a bad investment.
In fact, real estate can become significantly more valuable when its use changes and its economic density increases. For example, single family homes are more economically dense than wheat fields. High rises have a higher economic density than single homes. And so on.
What Ben Bernanke doesn’t understand, or hasn’t factored into his thinking, is that there is room for only so much economically dense property in this country.
Zero interest rates or not, if you strip out the debt that allows developers to construct projects that otherwise wouldn’t exist, the cash on cash return for housing is about what inflation offers over time.
Ergo, real estate is not the building block the Fed’s badly busted economic models think it is–at least not these days any way.