Governor Kohn Indicates Higher Interest Rates, Lower Real Estate Prices

Today the Vice Chairman of the Federal Reserve Board, Donald L. Kohn, offered remarks at the European Economics and Financial Centre Seminar, House of Commons, London, England, entitled Reflections on Globalization and Policies.

http://www.federalreserve.gov/boarddocs/speeches/2006/20060706/default.htm

As is often the case, the language is hard to decipher for a non-economist, but my take is that the Governor is indicating higher interest rates and lower real estate prices going forward, highlighting

in my view, asset prices on the one hand, and the dollar, inflation and interest rates, on the other.

Here are quotes from his remarks mentioning these variables (the bold type is mine).

1) Mention Of Asset Prices

a) "Various asset markets have experienced rather sharp fluctuations in prices in recent decades, some of which have threatened disruption in the United States and have contributed to sluggish growth elsewhere, as in Japan following the real estate boom and bust; we certainly cannot rule out the possibility of further sharp asset price movements as product prices and spending adjust."

b) "Sound public policies ... can contribute by facilitating needed adjustments in spending, production, and relative prices and by taking steps to foster strong, flexible product and financial markets that are resilient to more abrupt changes in asset prices and spending patterns, cushioning the effect of any such fluctuations on output and product prices."

c) "By ensuring that financial institutions are adequately capitalized and are managing risks well, and are in general well prepared to deal with major changes in asset prices, they are in a better position to weather any necessary changes in policy settings.”

2) The Dollar, Inflation, And Interest Rates

a) "Continued strong demand for dollar assets will be critical to keeping that unwinding smooth and not disruptive."

b) "The lesson from the 1970s, however, is that an unchecked or permanent increase in inflation would only feedback adversely on demand for dollars. Such an unmooring of the anchor of price stability could only elevate the odds on abrupt changes in interest rates and asset prices, instability in the US economy, and disorder in global adjustments."

In short, the Fed, along with many other observers, knows that debt-based spending in the United States, both private and government, cannot continue. One way out, the Fed hopes, is that investment and consumption demand will pick up in the rest of the world, allowing US exports to increase, by virtue of the productivity and saving in the corporate sector, and that US domestic demand will slow, in part through a downward correction in real estate prices (stock prices may come down, but most likely will continue to fluctuate and even drift upwards since the corporate sector is not so heavily indebted and is highly productive), while at the same time foreigners remain willing to hold US debt paper by virtue of competitive US interest rates.

In his remarks, the Governor is obviously addressing these variables from a long-term point of view. But he also states elsewhere in these same remarks that the long-run consists of series of short-runs. So, in my view, these remarks are further evidence that we can expect at least two or three more rate hikes by the Fed in the next three or four meetings, and that the downward pressure on the real estate market will continue, perhaps with some abrupt drops in several regions of the country in the next six to eighteen months, even as economic growth slows to a pace more in line with real productivity growth, and no longer inflated by excessive debt-based spending.