The April release of first quarter GDP showed a healthy increase of 3.2%. Our chief economist, Dr. Ed Seifried, questioned the number in his quarterly Economic Survival Kit webcast. Over time, Dr. Ed says there is a strong correlation between GDP and the ISM manufacturing number, which grew to a very expansionary 60.4 reading. Based on the ISM release, Dr. Ed estimates that GDP should be reading over 5%.
Inclement Weather Dampened GDP
Does everyone remember the snow days in the East during this past harsh winter? While enjoying the current warm weather, one wants to forget that Washington was actually closed for a period of time. Dr. Ed feels that this actually dampened the GDP.
As the income and spending discrepancies caused by inclement weather phase out, Dr. Ed further believes that second quarter GDP may show a significant leap that may convince the doubters that the economy is indeed in a recovery.
Shared Blame for Financial Crisis
But who put us in the financial crisis of 2008/2009, with the subsequent severe recession? “Blame the mortgage bankers, the investment firms, the “greedy” home buyers, Greenspan, and Bernanke," says Dr. Ed.
He makes a compelling argument that the products developed by the under-regulated mortgage bankers, that were snapped up by home buyers, that were packaged by investment firms, under the influence of interest rates that were kept too low, caused the bubble in the housing market.
If it Sounds too Good to be True...
From Federal Reserve research, Dr. Ed discovered that subprime and ALT A mortgages surged as a percentage of all mortgages written through 2007. The structure of these mortgages shifted from conventional to exotic. For instance, Dr. Ed tells of a home buyer faced with financing a $220,000 home. The home buyer is given a choice of a conventional 30-year fixed-rate mortgage at $1,079 per month versus a variable-rate mortgage at $960 per month or an interest-only mortgage at $700 per month.
The buyer feels that this is too expensive. The buyer is then shown a 40-year mortgage at $530 per month. The buyer is about to leave when the mortgage banker suggests two alternatives. They could bet a negative amortizing mortgage at $150 per month or a mortgage where they can choose what they can pay!
The Federal Reserve research estimated that people paid less than $150 per month. Dr. Ed dug further and found that people on average paid about $99 per month!
His point is that the home buyer should have known better. How can you “buy” a house for $220,000 for less than $150 per month? People can’t even buy a new car for that amount!
Low Interest Rates Fueled Real Estate Bubble
Dr. Ed also believes that because the Fed did not follow the Taylor rule, they kept interest rates in real terms too low. The Taylor rule has been integrated on a worldwide basis for determining the overnight rate of money. Yet, Greenspan felt that the Taylor rule was too restrictive. Bernanke has continued in Greenspan’s footsteps.
The Taylor rule is a formula that determines the overnight interest rate with a foundation that banks need a base rate of 2% to make a profit. Economic factors such as GDP and employment are factored into what the additional rate of interest should be based on the state of the economy. The Taylor rule has been accepted internationally because it has proven to optimize the economy. Yet, our monetary officials do not utilize this proven tool.
Dr. Ed shows that from 2004 to today, the Fed kept interest rates significantly below where the Taylor rule was pegging rates. Even as Bernanke raised rates, they were still below the Taylor rule levels. Essentially, the Fed fueled the expansion and the real estate bubble with under market priced money.
According to Dr. Ed, the economic expansion this quarter seems underestimated, and low interest rates are actually fueling a much stronger growth. He feels that the Fed, based on the economic expansion in progress, must raise rates to at least the 2% base of the Taylor rule and more progressively to the 4% norm, to prevent future bubbles and overheated economies that could lead to a repeat of the financial crisis of 2008/2009.