The Federal Reserve is gambling interest rate cuts can save America’s economy from recession and drops in trade.
Dramatically, the Fed cut America’s prime interest rate by 0.4% to 2.25% on 31 July 2019, The New York Times reports. Notably, this was the first interest rate cut since the Great Financial Meltdown of 2008.
However, it is not clear what America’s Central bank hopes to achieve by cutting interest rates. The theory behind interest rate cuts is that cheaper credit will encourage businesses and individuals to spend and buy more and stimulate the economy. Strangely, Fed Chairman Jerome H. Powell claims “The outlook for the U.S. economy remains favorable, and this action is designed to support that outlook.”
Ominously, Powell admits he sees storm clouds on the horizon in the form of “weak global growth and trade tensions.” However, Powell and President Donald J. Trump’s (R-New York) real worry could be a sluggish real estate market.
Why is the Federal Reserve cutting Interest Rates?
Cutting the interest rates may not help real estate market. In fact, interest rates were already at 4.75% on 31 July 2019, which is low, The New York Times notes.
To clarify, the average mortgage interest rate over the past 30 years was 6.25%. In contrast, Freddie Mac estimates the average mortgage interest rate was 3.75% on 1 August 2019.
New home sales fell by 2% between June 2018 and June 2019, The New York Times estimates. Moreover, investment in residential structures has been falling for six straight quarters. Under those circumstances new home sales are below their post 2008 peak in 2017.
Will Lower Interest Rates save Real Estate?
Thus Powell’s hope could be that lower mortgage rates will jump start home sales. In addition, it could help real estate.
Notably, President Trump and his family are in the real estate business. The President’s father; Fred Trump, started the Trump Organization as a home builder in New York City.
A related problem is that investors can make more money in other places like stocks. Notably, the Amazon (NASDAQ: AMZN) share price grew from $81.19 in August 2019 to $1,776.83 on 5 August 2019. Given returns like that investors have little incentive to buy real estate.
Can Lower Interest Rates Makes Homes Affordable Again?
However, I do not think lower interest rates will address the fundamental problem in real estate and housing: sky-high real estate prices.
For example, only 56% of home sales in the United States in 2018 were “affordable,” the National Association of Home Builders (NAHB) estimates. Affordable means the average family can afford to buy the home.
Moreover, the affordability crisis is getting worse fast. In 2012, the NAHB/Wells Fargo Affordability Index estimated 78% of the homes in America were “affordable” for the average family. Disturbingly, the NAHB projects that the Affordability Index could fall below 50% in 2019.
Thus one hope of Trump and Powell is that lower interest rates could make homes more “affordable.” Conversely, I think lower interest rates could make the housing affordability crisis worse.
Could Lower Interest Rates hurt the Economy?
Lower interest rates could raise real estate prices by making it cheaper to borrow money. Consequently, rich people and investors will borrow more money to buy more real estate with.
Property owners could make the situation worse by keeping real estate off the market in hopes prices will increase soon. A related problem is that a lot of real estate is still under water. To explain, a property is under water when the mortgage amount exceeds the price the owner can sell it for.
One reason real estate is not selling in many markets is that high mortgages force owners to list properties at prices nobody will pay. Consequently, markets become glutted with zombie properties nobody wants.
Is Another Subprime Crisis Coming?
The worst-case scenario is another real estate bubble in which lenders issue large numbers of mortgages to people with little or no money. Such subprime lending was one of the main causes of the 2007 to 2008 economic meltdown.
Disturbingly, some observers; including US Senator and presidential candidate Liz Warren (D-Massachusetts). fear another subprime lending crisis is developing. Specifically, Warren reveals she fears subprime crises in auto loans, household debt, and corporate debt at Medium.
Warren estimates that leveraged lending to companies has grown by 40% since 2017. Frighteningly, America is now the largest market for leveraged loans, Quartz estimates. The International Monetary Fund estimates that the leveraged loan market was worth $1.3 trillion globally in 2018, and $788 billion worth of those loans went to companies with weak credit ratings.
Specifically, I think such leveraged loans enable basket case companies like JC Penney (NYSE: JCP); which had a 68₵ price on 5 August 2019, to keep operating.
Interest Rates and the Retail Apocalypse
In fact, Penney reported a quarterly operating loss of -$154 million and a net loss of -$93 million on 4 May 2019. Yet, Penney can stay in because it can borrow lots of money to cover its operating costs.
Such lending hurts communities by keeping lousy retailers; that pay no taxes, in business. Moreover, stores like Penney’s take up land that owners could redevelop for profitable businesses or housing. In addition, it finances a zombie economy in which retailers pay people to work at stores with no customers.
The situation is cruel because such retailers cannot pay their loans at some point and suddenly collapse. Sadly, all low interest rates will do is prolong the inevitable retail apocalypse, and make the calamity worse by keeping bad companies in business. Notably, Coresight Research predicts over 12,000 stores will close in the United States in 2019.
The Strange Politics of Interest Rates
Many observers will wonder if President Trump and Powell hope lower interest rates can delay an economic downturn until after the 2020 presidential election. My guess is we will not feel the economic effects of the August 1 rate cut until 2021.
Thus, the lower rates will not affect the presidential election. Instead, Trump and Powell think they can prevent a recession and help average Americans with lower interest rates. Moreover, low interest rates are one of the few ways Trump can stimulate the economy.
The best way to stimulate the economy is with direct cash infusions by government. Such infusions can take the form of Social Security increases, reparations payments for African Americans, a Basic Income, increased government spending, public works projects, or federal grants to local and state governments.
How Politics Make Interest Rate Cuts Necessary
However, such spending could be impossible in today’s political environment. For instance, hard-right fiscally conservative Republicans who hate entitlements and big government control the U.S. Senate.
Meanwhile, Democrats control the U.S. House of Representatives; which writes the budget. Obviously, Democrats do not want to pass any potentially popular spending measures Trump can claim credit for going into an election.
Given demographics and ideological divides such Congressional gridlock is unlikely to ease soon. Tellingly, Powell agrees with such statements he even says of the interest-rate cut, “it’s not the beginning of a long series of rate cuts — I didn’t say it’s just one.”
Will Interest Rate Cuts Ease the Tariff Pain?
Another obvious hope is an interest rate cut could reduce the pain from the President’s new tariffs on Chinese goods. However, I do not see how interest rate cuts could ease the damage tariffs will do.
To explain, tariffs will raise the prices on a wide range of products almost every American busy. Interest rate cuts; on the other hand, only help certain classes of people such as corporate executives, property owners, homeowners, and business owners.
For example, The New York Times claims the tariffs will affect toys, video games, coloring books, scooters, and school supplies. Consequently, the tariffs will hurt average people.
Can Interest Rate Cuts Save the American Economy?
Powell and Trump are taking a huge risk because there is no guarantee cutting interest rates can boost the economy. Nor is there any evidence interest rate cuts will protect Americans from the effects of Trump’s tariffs.
Interest rates are a cumbersome and inefficient means of economic stimulus. For instance, it could take months; or years, for money spent on houses, autos, industrial equipment, etc. to reach Main Street. In addition, there is no guarantee that money will reach Main Street.
Moreover, speculators, financial institutions, and investors can siphon off most of the money interest rate cuts inject into the economy. For example, Sears Holdings Corp accuses former CEO and hedge operator Eddie Lampert and his associates of looting the department store brand in a lawsuit.
Who Benefits from Low Interest Rates?
One way Lampert allegedly looted Sears was to borrow against its real-estate holdings. Sears which shrank from over 3,500 stores to around 700 under Lampert’s “leadership” declared bankruptcy in October 2018.
Given this history, cynics will say Trump is rewarding financial interests that support him with low interest rates to raise money and support for his reelection efforts. Notably, Sears names US Treasury Secretary Steven Mnuchin; Lampert’s former college roommate, as a defendant in the lawsuit.
I think next year’s presidential race will be close and expensive. Thus, Trump and the Republicans will need every cent they can raise. Speculators who could benefit from rate cuts have big bank rolls. In addition, there are some groups of voters who could benefit from low interest rates.
Could Low Interest Rates help Trump Win Reelection?
Those people include real estate agents, bankers, mortgage brokers, contractors, and some small business owners. Notably, such individuals are probable Republican voters. Consequently, Trump could reward those classes for their loyalty.
Unfortunately, I do not believe lower interest rates will help most Americans. However, Trump does not need a majority to win reelection. In fact, the Donald lost the popular vote by 2.9 million; or 46.1% to 48.2% in 2016, CNN Politics calculates.
Notably, New York Times writer and number cruncher Nick Cohn thinks Trump could win “reelection with a bigger loss in the national popular vote.” In detail, Cohn’s theory is that Trump could pick up more Electoral College votes in conservative low-population states next year.
An obvious way to get such votes is to reward small businesspeople, bankers, speculators, investors, realtors, and other groups likely to vote Republican. Those groups could benefit from interest-rate cuts. Strangely, such efforts could hurt Republicans by reducing their popular majority; and number of House seats, by driving women, younger voters, and people of color away from the Grand Old Party.
The Future of Interest Rate Cuts
Therefore, I predict the interest rate increases will have little effect on average Americans but could benefit a minority likely to back Trump.
The interest rate cuts raise serious economic, philosophical, ethical, and political questions we must discuss. For example, how low can interest rates go? Could the economy and the financial system function with 1% or 0.5% interest rates?
Is it ethical to give Wall Street, the real estate industry, speculators, retailers, investors, mortgage brokers, and others cheap credit at the potential expense of average Americans? Remember, Uncle Sam had to bail out many financial institutions and two of the big three automakers with taxpayer money during the last financial crisis.
Finally, handing cheap credit to certain groups in the form of low-interest rates could intensify racial, class, economic, political, and regional divisions in America. Low-interest rates could make income inequality worse by allowing those with money to borrow and buy more. In addition, groups they historically exclude from the financial system; like blacks and working-class whites, cannot profit from lower interest rates.
Instead of fixing America’s problems, interest rate cuts could create new problems and make the economy worse. Every investor, and citizen needs to watch the interest rate cuts closely because they could lead to dramatic changes in our economy.