“The entrepreneur must estimate present and future costs and future revenues and therefore estimate whether and how much profit he will earn.” Murray Rothbard from Economic Depressions:Their Cause and Cure
We wrote back in June that the supply/demand inventory shortage would reverse in part because home builders would increase output to meet the artificially stimulated demand. Yesterday’s housing starts report shows that prediction to have been correct.
Home builders are falling for the trap.
Low Interest Rates and Rising Home Prices Encourage Home Builders to Increase New Construction
Home builders are taking their cues, not from the health of the overall economy and the ability of their potential customers to buy homes, but rather from the cues sent by the Fed’s artificial manipulation of interest rates lower through Quantitative Easing (QE). This in conjunction with low for sale inventory has artificially stimulated demand and driven home prices higher and encouraged home builders to rush to meet demand.
Taking business decision cues from the Fed may be sensible but its also dangerous because the Fed, while it has a great influence over the direction of interest rates, will not ultimately dictate the direction of interest rates, the market will – and that direction is higher.
There is a disconnect between rising home prices and the weak health of the economy. The continued weakness in the economy caused the Fed to acquiesce yesterday to the continuation of its $85 billion a month U.S. Treasuries and mortgage backed securities (MBS’s) buying program. More QE should mean lower rates (at least in the short term) because the Fed’s continued purchases of U.S.Treasuries and MBS’s artificially boosts demand for those securities and drives rates lower than the market, absent Fed intervention, would be willing to accept. Take the Fed away as a buyer of U.S. treasuries and MBS’s and rates rise.
We saw over the past few months that the mere talk by the Fed of tapering QE purchases caused interest rates to skyrocket and the Fed’s backtracking from tapering yesterday caused rates to plummet.
The Fed may find itself in the world’s most expensive liquidity trap in the coming months as interest rates may ultimately rise and economic growth remain stagnant no matter how many $billions of securities they may buy. That is the real danger for anyone investing, including home builders, based on the false signals that the Fed is sending by manipulating interest rates lower. Higher interest rates would be a disaster for the housing market and new home builders. Yet home builders are taking comfort in the still relatively low interest rates, the Fed’s ability to keep them low and incessant media reports that the economy is recovering.
The artificially Fed induced low interest rates are perhaps sending a classic false signal to home builders causing them to make “malinvestments” in Mises’ terminology or over investments in new construction during the current boom/recovery period.
Many home builders made this mistake in the early and mid 2000’s leading to this not so creative destruction of their own inventory:
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