For the first time in over four years, the Federal Reserve is about to start raising interest rates - an action that it is likely to do repeatedly for the foreseeable future.
If the Fed does start to tighten the money spigot when it sets interest-rate policy Wednesday, it will mark the end of one of the longest period of low interest rates in recent times. And, as interest rates start to tick up - probably by only 1/4 of a point to start with - it will affect everyone from home buyers to the heavily indebted who carry significant balances on their credit cards.
The Fed's actions, however, will also indicate to the financial markets and the public that it is convinced that the US economy has turned the corner and can absorb the greater costs of money.
"The Fed's goal is to take its foot off the gas," says Richard DeKaser, chief economist at National City Corporation in Cleveland, Ohio. "It hasn't even begun to step on the brakes."
As the Fed raises interest rates, economists are trying to estimate the effect on the economy. In the past this was relatively easy to estimate. But now Americans have complex debt arrangements. For example, many people in refinancing their homes have consolidated their car and credit-card debt into their mortgages. "So, they are sheltered from the liability from interest-rate increases," says Mr. DeKaser.
Some of those who are not sheltered, however, include people taking out adjustable rate mortgages (ARMS) which may move up or down with short-term rates. Although many have interest-rate caps, including over the life of the loan, the rates can rise.
For example, Fannie Mae, the nation's largest source of financing for home mortgages, is projecting rising rates through the end of the year. It estimates that for someone who took out a $200,000 one-year ARM late last year, the mortgage payment could increase from $926 a month to $1,086, or about 17 percent by year-end.
The University of Michigan Surveys of Consumers, in fact, finds that people do expect the cost of borrowing to rise for the next several years, says Richard Curtin, the director of the Surveys. "That's a negative on the part of most consumers, but they expect that higher rates means more jobs," says Mr. Curtin in explaining why rising rates may not dampen spending immediately. "More people are expecting higher rates than ever before but that goes along with the fact rates are lower than ever before."
Those lower rates - and the prospect of higher ones - may be one reason why new-home sales are soaring.
Last week, the Commerce Department reported that new-home sales in May jumped 15 percent to a record level. "What I think we're seeing now is people who were fence sitting [are] jumping in, and that's accelerating the market," says David Seiders, chief economist for the National Association of Home Builders in Washington.
Home building flurry expected
This surge may continue for a few more months. Mr. Seiders estimates it takes about four to five months from the time ground is broken for a new home to the time the welcome mat is placed outside the front door.
Despite this strength, Seiders expects the new-home market to start to slow down in the second half of the year - probably by about 6 percent. "It's not a big move," he contends, "and we're historically at a good level."
Yet any housing slowdown will have a spillover effect on the economy. Last year, more than 10 percent of the nation's 3.1 percent growth rate was directly related to housing. It's currently still running about that rate - about double its historic contribution to the economy.
Housing is even more important in terms of its indirect contribution. When individuals buy a new home, they often buy new furniture, appliances, carpeting, lighting, even azalea trees. When all is totaled, 20 percent of the US economy may be related to housing, estimates Seiders.
Home values have been growing even faster than builders are pouring new footings. In some parts of the nation, such as California, New York City, Boston, and Washington, houses are up as much as 25 percent over the past year. Last week, the National Association of Realtors reported that nationally, prices of existing homes in May were up 10 percent over than May 2003.
The sharp rise has made some question whether the sector is "the next bubble." But in a study released last week, the Federal Reserve Bank of New York says it doesn't look like a bubble about to burst. Although some markets may be overbought, that's not the case on a national basis, say senior economist Jonathan McCarthy and vice president Richard Peach.
"We're not suggesting there are not pockets of exclusive areas where prices are up dramatically and they can come down dramatically," says Mr. Peach in an interview. "The main point we want to make is that the measures that people use to support the view that there is a bubble are flawed."
For example, Peach says the large drop in nominal interest rates in the past few years has meant that home buyers can afford larger mortgages. In 1990, the average nominal interest rate of a 30-year fixed-rate loan was more than 10 percent; today, it is closer to 6 percent. "Combined with a 50 percent increase in median family income, there's been a 130 percent increase in the mortgage a family can qualify for," he says. "Over the same period, home prices are up 72 percent - so it's a wonder [that] home prices have not risen [even] more under the circumstances."
Peach also disputes the view that an increasing number of home buyers using adjustable-rate mortgages during a time of rising interest rates constitutes a threat to the economy. "We have seen this before in the beginning of 1987 when there was a fairly big run-up in rates in a short period of time, and the world did not come to an end."