Federal Reserve Economic Forecast Off-target

Low interest rates may be a bane to savers’ retirement plans, but they have been a blessing to home builders. As the Federal Reserve has continued its quantitative easing programs to keep interest rates near zero, single family home starts are expected to increase 25 percent in 2012 from a year ago. Low interest rates allow buyers to purchase houses with lower monthly mortgage payments, which boost demand for homes. UBS Investment Research economist Maury Harris told USA Today November housing starts are expected to total 900,000, compared to 894,000 in October. While still lower than the 2.68 million housing starts in 2006, it’s a substantial improvement over the mere 554,000 in 2009.

As housing demand increases, so does value of existing homes. As people can sell their homes for a profit, they are able to afford a higher-priced house. More people buying and selling homes is good news for the construction industry—and construction jobs lost during the recession. Decreased unemployment is the ultimate goal of the Federal Reserve’sstimulus programs, although the Fed’s current forecast suggests the jobless rate won’t hit its target of 6.5 percent until mid-2015.

Some economists feel the Fed’s forecast is too conservative, however. The current unemployment rate is 7.7 percent—1.2 percentage points above the target. If it, in fact, takes 30 months to fall by that margin, it would be double the time it took to fall the same stretch to where is currently sits.

In an interview with USA today, Barklays’ US economist Dean Maki pointed out 14 months ago the unemployment rate was at 9 percent. For the Fed’s forecast of 6.5 percent in 30 months to be accurate, many of the more-than 4 million people who left the workforce since 2007 would need to begin looking for work once again—thereby raising the unemployment rate.

Maki does not see such an increase happening, as he believes many of those who left the workforce were aging Baby Boomers who actually retired. If they remain retired, unemployment will fall to 7.1 percent in the next year and could reach the Fed’s target by early 2014.

Economist Joel Naroff agrees with Maki’s estimates.

“If my forecast is correct, we should see the Fed’s bond-purchase program end by the end of next year and rate hikes start sometime during the first half of 2014,” Naroff said.

The Fed has not announced whether it will change its interest rate policy if the unemployment decrease exceeds its expectations.  IHS Global Insight chief insight economist said the central bank could justify continuing its low interest rate policy if wage growth remains weak, even if joblessness decreases sooner than expected.

“The Fed said (6.5 percent) is a necessary but not sufficient condition for tightening,” Maki told USA Today, adding that the bank’s move away from telling markets it expects to keep rates low for at least two more years “gives them flexibility in either direction.”

When rates finally do increase, the change will be sudden and without warning, according to Stanford economist and former Treasury official John Taylor.

“Even a gradual (increase) will be a surprise because in history, the most difficult thing in central banking to me is really when to withdraw if you like the stimulus and how to create a softlanding, sometimes it’s called,” Taylor told The Motley Fool.“And it’s the most difficult thing because the instruments are not perfect.”

The Office of the Comptroller of the Currency echoed Taylor’s statements in a Dec. 20 report on risks to the banking industry. According to the OCC, future increases in rates may decrease the value of financial institutions’ mortgage securities.

“After three consecutive years of record low interest rates, banks are unlikely to realize further benefits from lower funding costs,” the OCC said in the report. “They face fundamental changes in their business models as a result of weakening revenue growth, including shifts in the role of trading, securitization, and consumer fee income.”

History shows an increase in federal funds rates often result in a boom-bust scenario, according to Taylor, but it can be avoided with careful planning.

“It’s been rare where we’ve been unable to avoid… the boom-bust and have really a smooth growth, and I think the eighties and nineties were really examples where we avoided much of the boom-bust, but it’s hard,” he said. “And that’s why I come back at that kind of policy, is where we should try to focus. Not exactly; the world is different, but that kind of steady as you gowhere people can anticipate. And even if you can see rates are moving up, if you can anticipate that, it’s going to be much better than surprise increases.”