Light at the End of the Tunnel...Part III

Is the light at the end of the tunnel an oncoming train bringing inflation down the tracks?

Marcelo is certainly right that the goings on in the housing market are exactly what needs to and should happen. Prices are falling and eventually they will fall to a market clearing price. Falling interest rates could also hasten that process. One fly in the ointment though is that the rates which most affect mortgage rates are not falling yet. The 10 year Treasury Note yield actually went up yesterday and is up again today. I don't expect that to continue but as long as it does, mortgage rates are not likely to fall much.

Why are rates on longer term paper not falling? My guess is that the bond vigilantes of old are making a comeback of sorts. The Fed cut interest rates yesterday to spur growth but in doing so they may also be feeding future inflation. Gold rallied almost 9% this month as the market anticipated the rate cuts. Oil is making new highs. This story sounds familiar to those of us who lived through the leisure suits and inflation of the 70s (something that Marcelo didn't have to endure).

I have said that reflation by the Fed will work and I'm sure that it will. We still have deflationary tendencies at the consumer level due to low cost imports and that allows the Fed to cut rates. The price for that cut is asset inflation for now but somewhere in the future, it will turn into actual consumer inflation (assuming the government doesn't find some new way to mask the increase through another manipulation of the CPI). I don't think we are there yet, but it will arrive someday.

As for the housing market, I think Marcelo is right - there is light at the end of the tunnel. We are probably not at a bottom yet, but if our cycle goes anything like the recent cycles in Australia and the UK, we are likely to see at least some stabilization as the Fed cuts rates. We aren't headed back to the recent past of rapidly rising prices, but we could at least begin to see some of the inventory cleared out over the next six months or so. My stance all along has been that the housing mess will not cause a recession and the Fed's rate cut yesterday just reinforces that opinion.