You may be wondering how we went from a booming economy a year or so ago to where we are now. Although economics doesn’t always do a good job at predicting the future, it does very well at explaining the past. So let’s take a look at what happened.

It all started in 2001. There were concerns that year that the economy would slip into recession after the technology boom of the 1990s came to an end. In response, the Fed began cutting interest rates. From May through December 2000, the federal funds rate sat at 6.5 percent. The average effective rate on a fixed-rate mortgage that year was 8.25 percent.

The Fed cut the federal funds rate by half a percentage point at five consecutive meetings beginning in January 2001, bringing the rate to 4 percent in May. The Fed then cut the rate by a quarter of a point at meetings in June and August 2001.

When the attacks of September 11th occurred, this renewed concerns that the economy would slip into recession. In response, the Fed continued to cut rates, increasing cuts to half a percentage point at meetings in September, October, and November, and then by a quarter of a point at the meeting in December 2001. The Fed then cut the federal funds rate twice more, bringing the rate to 1 percent in June 2003 and leaving it there for a year. This was the lowest rate in nearly half a century.

Here’s the effect this had on average effective mortgage rates: Rates dropped to 7.11 percent in 2001, 6.69 in 2002, and 5.88 in 2003. In 2004 and 2005, rates inched upward to just over 6 percent. In Cochise County, new home permits went from 653 in 2002 to 926 in 2003, 1,046 in 2004, and 1,108 in 2005.

The explanation for this can be found in the economic law of demand. It states that, if the price of something goes down, the quantity demanded goes up, other things being equal. In this case, the price of a home, at least in terms of the monthly payment, went down because the interest rate when down.

The increase in the demand for homes then caused home prices to rise. In 2002, the median home price in the Sierra Vista area, which accounts for more than two-thirds of the countywide market, was $117,000. This jumped to $134,000 in 2003, $163,000 in 2004, $200,000 in 2005, and just under $220,000 in 2006 and 2007.

The higher prices led builders to expand production, and also created an incentive for homeowners to sell. Then people began buying second or third homes, with the intent of holding onto them for a time and then selling them at a higher price.

When we talk about the Fed lowering interest rates, it’s important to understand that the Fed has no power to dictate the federal funds rate. The federal funds rate is the rate banks charge each other to borrow money overnight, and that rate affects interest rates throughout the economy.

Instead, the Fed influences this rate by buying and selling government securities. When the Fed wants to raise interest rates, it increases its sale of securities to commercial banks, so money flows from the banks to the Federal Reserve. This means the banks have less money to lend out, and this decrease in the supply of lendable funds raises the price (the interest rate is the price we pay to borrow money).

When the Fed wants to lower rates, it does the opposite: It buys back securities from the banks. This sends money to the banks, thereby increasing the supply of money in the banking system. The result is more money is available to lend.

The Fed’s interest rate cuts from 2001 to 2003 increased the supply of money in the banking system, encouraging lenders to lower the credit standards for lending in order to lend the additional funds. This gave rise to the subprime mortgage boom. A subprime mortgage is a mortgage given to people with less than good credit.

The lower standards meant a higher level of risk, the cost of which had to be covered somewhere. It ended up being covered with a wider range of rate increases on adjustable rate mortgages. Also, these were higher risk borrowers, so they were more likely to default. The result was higher foreclosure rates.

More foreclosures meant even more homes were added to the market, which increased supply at a time when demand was going down. This put further downward pressure on home prices, which leads us to another dimension of the problem. Home prices are highly flexible upward, but not so much downward. This is because sellers have to pay realtors’ commissions and other costs at closing. Also, many homeowners took home equity loans, which have to be paid upon the sale of the home. The result was a huge slowdown.

So that’s where we’re at now. In response, the Fed is lowering interest rates. They’re trying to extend the life of the housing boom, with the hope that the lower interest rates will also give rise to some other boom, since lowering interest rates not only increases home sales, but also increases consumer spending and business investment.

The wisdom of using this approach is certainly debatable. On one hand, the interest rate cuts at the end of the technology boom gave rise to the housing boom, so the general economic slowdown was short lived. On the other hand, it also brought us to where we are now.

If all this isn’t bad enough, there’re a couple other problems to add to the mix. We’re currently looking at very real inflationary problems. Last year the inflation rate was 2.8 percent, but in the past 6 months prices have been about 4 percent higher than in the same months a year prior. In October last year, wholesale prices jumped 3 percent in one month, the largest single-month increase in 35 years. That’s a level of increase you’d expect to see for a whole year. In January of this year, wholesale prices were up another 1 percent. Wholesale prices in January were 7.4 percent higher than January last year.

This is primarily the result of higher energy prices, since energy serves as an input cost to most goods and services. Energy prices have remained high for much of the past couple of years. While short-term increases in energy prices typically don’t have an appreciable effect on the prices of other goods; sustained increases will spill over into wholesale, and eventually consumer prices.

The danger is that the higher prices mean people have less purchasing power, which means they have to buy less. This means less will be produced, which means fewer workers are needed, so higher unemployment will soon follow.

Inflation has the potential to become a big problem. In the late 1970s and early 1980s we saw 3 consecutive years of double-digit inflation. Also, in 1974 and 1975 we saw annual inflation rates up around 10 percent. These were stagflationary years, which means we had high inflation and high unemployment at the same time, which is a rare but dreaded occurrence. The unemployment rate in 1975 was 8.5 percent, and in the early 1980s we saw unemployment rates close to 10 percent. These periods were also characterized by high gas, oil, and energy prices, a problem we’re currently facing.

The problem is that higher energy prices lead to cost-push inflation, which does not vary inversely with unemployment the way demand-pull inflation does. With the inflationary trends we’ve seen recently, and the impending economic slowdown, stagflation is a very real possibility for 2008 and 2009. So that’s a short explanation of where we are and how we got here. 

If you have any questions on the economy, please contact the CER at (520) 515-5486 or email us at cer@cochise.edu. Be sure to check out the CER’s website at www.cochise.edu/cer.