Will the Actions of the Fed and Treasury Keep Asset Prices Artificially High?

BY busadmin  June 25, 2009 at 10:23 AM EDT

house; via Flickr

Question: It seems to me like the Fed and the Treasury are trying very hard to keep asset prices high. The Fed has vastly increased the money supply, partly by lowering interest rates to zero, and partially through quantitative easing. The Treasury has a robust homeowner program, plus continuing bailouts of Fannie and Freddie.

Will this work to stabilize asset prices at “artificially” high levels? What will happen to asset prices if the Fed is forced to raise interest rates to combat inflation? It seems to me like they will fall further because the financing of the debt on those assets would become more onerous. On the other hand, a home is a “hard” asset and should rise with inflation.

Paul Solman: Nicely put, Nabil. Your question points to the problem of the moment: that the U.S. economy is between a rock and a hard place, in danger of going from the frying pan into the fire, on the horns of a dilemma — pick your cliche.

The U.S. government, U.S. consumers, the state of California, homeowners galore — all were running deficits. That is, all were spending more than they earned. As many a sober observer was at pains to point out, that meant we were “living beyond our means.” Which is to say: we made promises, based on a presumption (or prayer) of future income, though we didn’t necessarily believe them. It’s what Alyssa Katz, journalist and author of the new book Our Lot: How Real Estate Came to Own Us, recently called, on this page, the Edmund Andrews syndrome. (See this if you don’t know to what she’s referring.)

These promises were our mortgages, our credit card balances, our bonds. (“Our word is our bond” was not good enough.)

Any wonder that almost all these promises are now worth less than they used to be?

In fact, the real surprise is that UNCLE SAM’S promises — Treasury bills, notes, and bonds — have NOT lost value. That seems to have been a function not of investor FAITH in them, however, so much as LACK of faith in every other alternative.

So just as the United States was borrowing more money and “printing” more money (“quantitative easing”) while at the same time lowering interest rates, the world’s frightened investors were flocking to Uncle Sam’s promises. That’s what’s GOOD about being the world’s safest haven. Imagine if we were Argentina. Or Mexico.

It is no surprise, then, that as investor panic subsides and our borrowing and “printing” still increases, investors are having second thoughts, and want us to pay a higher rate of interest for their loans. Wouldn’t YOU?

Your question is: What happens to asset prices? The answer is: Not clear.

Yes, if the Fed buys mortgages and mortgage-backed securities, the price of housing will be higher than if the Fed doesn’t.

“Artificially”? I don’t know what NON-artificial would mean in a country where housing loans are as subsidized as they are in this country, and have been for decades. And I don’t just mean Fannie and Freddie guarantees. How about the tax deductibility of mortgage interest? Doesn’t that make home loans artificially cheaper than they “should” be?

But you end with the following thought: “a home is a ‘hard’ asset and should rise with inflation.”

In general, that might be true. But to continue with the reasoning, if the tax deductibility of mortgage interest were to be repealed, for example, then all else equal, the value of housing would DROP, no? Okay, repeal is unlikely. But if interest rates go UP, as you suggest they must, then mortgages will become more expensive, fewer people will be able to afford homes at today’s prices and again, all else equal, this “hard asset” might go down in value.

Of course, all else is NOT equal. You’re positing inflation. That means the dollar is worth less. That means anything priced in dollars, like oil or a home, should go UP in price. All else equal.

You can see, I trust, why the answer is not so clear.