Interest Rate Roundup

Thursday, January 11, 2007

An interest rate surprise across the pond ... and some thoughts on housing affordability

At least one major, global central bank apparently thinks surging liquidity, soaring credit availability, still-high inflation rates, and exploding asset prices are a threat. I say that because the Bank of England just hiked interest rates by a quarter-point, or 25 basis points. This came as a complete shock to the experts, who expected the BOE to keep rates flat.

The European Central Bank, meanwhile, kept rates flat as predicted. But in the post-meeting press conference, ECB president Jean-Claude Trichet pointed out that "the rate of monetary and credit expansion remains rapid" and that "monetary developments continue to require very careful monitoring."

British short-term rates are now dead even with U.S. short-term rates at 5.25%. It looks like the BOE was spooked by the fact that U.K. retail prices gained the most in almost three years in November ... the fact that November overall inflation was 2.7%, the fastest rate in at least a decade ... and the fact that home values are rising fast again after taking a breather in 2005.

Speaking of home prices, the Financial Times had a great story about the problems brought about by the surge. A study from the Royal Institution of Chartered Surveyors concluded the average U.K. couple needed more than $63,000 to cover the costs of buying a property (the deposit, stamp duty, etc.). That's a whopping 82% of annual take home pay. Ten years ago, buyers needed to spend just 25% of their pay.

Am I the only one who thinks this is ridiculous? It shows the danger of a myopic focus on pure CPI-type inflation, and a complete disregard for ASSET inflation. U.S. Fed officials repeatedly commented during the housing boom that surging U.S. home prices were essentially not their problem. The result: Home prices exploded and got completely out of reach for average buyers using traditional loans. People were forced to turn to riskier products, like option ARMs, 40-year and 50-year mortgages, and interest only loans. And surprise, surprise, all that risky financing is now blowing up in our faces, with defaults and delinquencies surging.

All in all, I think home prices will need to stagnate or fall for much longer than the market realizes to sort this mess out. I mean, even now, many American workers still can't really afford median-priced homes, according to a just-released study. It points out that you need an annual income of nearly $85,000 to really afford a median priced home (assuming "old," prudent buying standards, like putting 10% down and spending no more than 28% of your income on the monthly principal, interest, taxes and insurance payment). Actual U.S. median household income was $46,326 in 2005, according to the Census Bureau.


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