How The Fed Could Kill The Recovery

I agree with Karl Smith about all things business cycle, but I don’t think he’s explaining what’s important in this from the National Association of Home Builders as clearly as he should. But it’s an important story that illustrates how the economy will be won or lost over the next several months:

The apartment sector is a bright spot in the overall housing market leading the industry’s path to recovery. However, the lack of credit to finance the development of new apartments is likely to cause a supply and demand imbalance, said panelists during a press conference held today at the National Association of Home Builders (NAHB) International Builders’ Show (IBS) in Orlando, Fla.

Multifamily housing demand will outpace current capacity to finance production and could put the brakes on the recovering industry. “While we are forecasting construction of 208,000 multifamily residences in 2012, that figure is well below the 350,000 units a year that is needed to maintain balance in the market,” said Sharon Dworkin Bell, NAHB senior vice president for multifamily and 50+ housing.

As Smith says the important thing is that Bell is not “suggesting that we have entered into some new regime where it doesn’t make sense to build apartments. No, the bank simply will not fork over the cash.” The economy is working when we’re in a situation where loans are available for profitable construction. At that point, savings and investment are balancing in the right kind of way. Now over time if we hold things steady we will find that the bank situation improves. The population keeps growing and the existing housing stock keeps deteriorating, so building more becomes a more and more attractive proposition.

“As the natural rate of interest rises,” Smith says, homebuilders “will find that banks become more willing to lend.”

But there’s an important point in the process here where rents are likely to go up because banks have under-lent and thus we’ve underbuilt. This rent spike is going to be an unfortunate situation for renters with poorly timed contracts, but it’s a critical moment on the road to recovery. We need to power through it. The risk, however, is that rent is an extremely large element of the “core CPI” even though most Americans don’t rent and most renters are on long-term contracts. This means there’s some risk that the Federal Reserve will stomp on a nascent recovery at the worst possible moment in response to a transient spike in the spot price of rental housing. The most important thing for the American economy in the short-term right now is probably not Greece or Europe, but whether or not the Fed will commit to not doing this. The things they’ve been saying recently are mostly reassuring on this score but they’re not nearly as clear or firm as I’d like to see. But the speech Bernanke is supposed to deliver in about twenty minutes to the NAHB would be a great opportunity to clarify. Central bankers seem allergic to clear language, but the sentiment I’m looking for is: “America has a lot of idle homebuilding capacity at the moment, so I would actually welcome an escalation in rent rather than viewing it as a dangerous sign of incipient inflation.”