Economics: In my last column I attempted to unravel a conundrum that is currently exercising the minds of economic commentators across the world. How is it that the global economy (the US economy in particular) continues to enjoy reasonably buoyant growth in the face of the unusually sharp increase in oil prices that has occurred over the past 12 months or so?
By way of answering, I made a number of suggestions: that the full impact of higher oil prices would only be evident with a lag, that households and firms had taken the view that much of the oil price increase was transitory and so on.
I also made the point that the fact that economic activity had not slowed down perceptibly did not mean that the oil shock had not already had some negative effect, in the sense that growth would likely have been higher in its absence. An implication of this is that other influences have been offsetting the oil price impact.
One of my readers helpfully identified one of the factors concerned, a factor that is especially important in the US - namely equity withdrawal in the housing market. In the year to date, the injection of purchasing power delivered by equity withdrawal has greatly outweighed the draining of purchasing power caused by higher oil prices. The former has been worth something in the region of $140 billion (€115.25 billion), the latter about $40 billion.
Of course, equity withdrawal is a bull market phenomenon. It is hard to imagine it being a potent force in a stagnant or declining housing market.
The fact that equity withdrawal has been taking place at all, therefore, draws attention to another conundrum that marks US economic activity at the moment. That conundrum is the coexistence of a continuing boom in US house prices with a very substantial rise in US short-term interest rates.
Since the middle of last year, the US Federal Reserve has increased US interest rates on no fewer than 11 occasions (the most recent being this week). As a result, short-term rates in the US have risen from 1 per cent of 3.75 per cent over the period. It might have been reasonable to suppose that a move of this magnitude would have cooled the ardour of house buyers somewhat and brought galloping house price inflation to a halt. Indeed, the Fed's decision to tighten monetary policy was almost certainly based in part on this kind of reasoning. However, the expectation has proved quite misplaced.
Latest available official data indicate that US house prices are rising by 13.4 per cent year-on-year, the fastest rate of house price inflation since 1979. Incidentally, the 13.4 per cent is a national average, and might not seem remarkable by recent Irish standards. But there are many areas of the US where house prices are currently spiralling upwards at a 25 per cent-plus rate, indicating a doubling time of less than three years. The hottest of the hot spots are to be found in California and Florida. In Bakersfield, California, for example, house prices rose by 34 per cent in the 12 months to June. In Naples, Florida, the corresponding increase was 36 per cent.
So what has happened? Well, one critical development has been the behaviour of what is called the "yield curve". While short-term interest rates have risen sharply over the past 12 months or so, long-term rates - that is, rates further out on the curve - have been falling, and it is these rates that are more important for the US housing market. Thirty-year yields, for example, have fallen by over one percentage point from their mid-2004 highs (from 5.5 per cent to 4.4 per cent) while 10-year yields have dropped by more than half a percentage point over the same period. So, despite rising short-term interest rates, mortgages linked to longer term rates have become more affordable.
But other things have been happening, too. There has been rapid innovation in the mortgage market, a result of which has been huge growth in non-traditional mortgage products. Traditionally in the US, the 30-year fixed rate mortgage predominated. Recent years have seen the arrival of increasingly exotic new mortgage types, including hybrid adjustable rate mortgages, interest-only mortgages and negative amortisation (or, increasing principal) adjustable rate mortgages ("Neg-Am ARMs").
These mortgage types have all been developed to circumvent affordability constraints in the context of rapidly rising house prices. In other words, they all offer, albeit to varying degrees, the prospect of a much more manageable repayment schedule than the traditional product, at least in the initial years of the mortgage.
On the other hand, they all have the characteristic that, after the initial period (typically five years) there is a significant payment shock - in plainer language, a big increase in monthly payments. Some of the numbers are downright scary.
Assuming interest rates evolve as currently expected, the monthly payment on a $250,000 interest-only adjustable rate mortgage will rise from $1,172 to $1,713 when it resets after five years. An even more extreme example is provided by the Neg-Am ARM product, where the monthly payment on a $250,000 loan is a seductive $880 in the first year, but rises very sharply in the sixth year to over $1800. What chance is there that someone who can just about afford a $880 monthly payment today will be able to manage $1,800 in five years?
And don't think for a moment that this kind of product is one that is confined to a narrow niche of the mortgage market. Far from it. The negative amortisation product is becoming the norm rather than the exception in the US, especially in areas of rapid house price inflation like California, Nevada and Florida.
What this illustrates is the extent to which US households have been taking on dramatically increased financial risk in recent years. Critical to their willingness to do so has been their belief that house prices will continue to rise.
But the inverse is also true: house prices have continued to rise because of households' willingness to take on increased risk.
If the circuitous causality at work here makes you feel a little queasy, you are not alone. Only so much air can be blown into a bubble.
Jim O'Leary lectures in economics at NUI-Maynooth. He can be contacted at jim.oleary@nuim.ie
