Fearing continued economic stagnation and high unemployment, the Federal Reserve recently announced a policy of “quantitative easing” as a panacea for these ills. Quantitative easing is what non-economists call “turning on the printing press.” It describes an extreme form of monetary policy used to stimulate an economy when the interbank interest rate, which in the United States is called the federal funds rate, is either at or close to zero.

However, there is broad diversity of opinion about whether using $600 billion to purchase bonds will work, even among the Federal Reserve’s board of governors.

“[Quantitative easing] won’t push inflation to ‘super ordinary’ levels,” said Fed Chairman Ben Bernanke last November. About a week later, however, board member Kevin Warsh said, “The Federal Reserve is not a repair shop for broken fiscal, trade or regulatory policies. Given what ails us, additional monetary policy measures are, at best, poor substitutes for more powerful pro-growth policies.”

Many residential home builders wonder what this policy will mean for their ability to profitably secure land and develop new homes. What seems likely is that inflation in the United States will increase, the dollar will depreciate in value, and dramatic commodity price increases will take place. Unprepared developers and builders will be punished by these environmental changes in 2012 and beyond.

Role of the Fed

The Federal Reserve controls the interbank borrowing or federal funds rate and pushed this rate down to essentially 0 percent. This rate is the cost for reserve system member banks to borrow funds and, in theory, lend these amounts to individuals and businesses. Exhibit 1.1 displays a 40-year period covering seven recessions and comparing the federal funds rate to one measure of inflation (CPI) and the U.S. unemployment rate. At essentially 0 percent, the federal funds rate is much lower than it has ever been during this 40-year period, and both inflation and unemployment are at their historical extremes.

By adjusting the federal funds rate, the Federal Reserve effectively steps on the brake or accelerator for the economy. The federal funds rate indirectly affects interest rates that developers and residential home builders pay for financing through lines of credit, debt or corporate bonds. When the federal funds rate goes down, the interest rates these firms pay for various forms of credit can fall. A low federal funds rate traditionally boosts economic growth, but in this case it has not sparked a higher growth rate or reduced unemployment.

Long-Term Credit Markets

Adjustments to the federal funds rate tend to have low impact on the cost of longer-term forms of credit, such as treasury and corporate bonds. The interest rate or cost for these credit instruments are more directly tied to longer-term economic risks faced by both the borrower and lender. This explains in part why a slight fall in longer-term rates has occurred but they are still within historic ranges, particularly for long-term treasury and corporate bonds.

Exhibit 1.2 presents the coupon rates for 1-, 10-, and 30-year treasury bonds over the past 40 years. Both 10- and 30-year bonds are at the low end of their historic range while 1-year treasury bills are at unprecedented low rates.

Another way to look at how investors are anticipating market risks to rise or fall is to prepare a yield curve comparison. Exhibit 1.3 depicts the yield curve for treasury bonds as of Dec. 30, 2010, for maturities ranging from 1 month to 30 years. This particular yield curve is classified as a “normal” yield curve reflecting an expectation of increasing risk meriting higher yield or return as the term lengthens.

Quantitative Easing as Alchemy?

Given that there is little more that the Federal Reserve can do with interbank borrowing rates, it has moved to a policy of quantitative easing. The Federal Reserve is going to essentially create the $600 billion necessary to implement this policy either by crediting the accounts of banks and brokerages from which it buys securities or printing currency through the treasury. The net effect of either approach is the same; it places more currency into circulation. This is manufactured demand for bonds and an increase in the money supply.

The first round of $75 billion was undertaken in November 2010, a second round of the same amount occurred in December 2010, and subsequent monthly expenditures are expected through June 2011. Over this implementation timeline, the result will be a more direct lowering of the long-term rates for bonds, as higher rates are not necessary any longer to attract the dollar investment. In addition, $600 billion in new liquidity injected into the system will result in more money sloshing around with the hope it will get the economy growing at a higher rate, resulting in additional jobs to drive down the unemployment rate.

What is taking place is similar to a chemistry experiment. The Federal Reserve is going to pour a catalyst (the $600 billion dollars) into a liquid (the economy) and see what happens. We already know that this catalyst will cause a chemical reaction, we just do not know if the $600 billion is enough catalyst to cause an observable or visual reaction — higher economic growth rates and more jobs.

While the $600 billion is applied, there will be vigilant observation of the economy to see what happens. If little is observed over some time period, a decision about additional expenditures and pouring more catalyst into the economy will be made. The problem with this approach is no one can really knows either how much catalyst is necessary to have a visual reaction or how long to wait to observe this reaction. Therefore, it is more likely we will get the mix wrong, as there are many more wrong answers than there are right ones. If the Federal Reserve is wrong on the too much catalyst side, we will experience high inflation, and if it is very wrong, potentially hyperinflation. There are nearly 20 recent examples of hyperinflation over the past 50 years around the globe. Several notorious devaluations include:

Argentina (1975-1991) — Suffered three rounds of printing progressively larger denomination bills finishing with a 1,000,000 pesos denomination. Three rounds of currency reform were implemented to drive down inflation.  The overall impact of hyperinflation: one 1992 peso = 100,000,000,000 pre-1983 pesos.

Brazil (1986-1994) — The base currency unit was adjusted three times, concluding with a currency reform and adoption of the real in 1994. The overall impact of hyperinflation: one 1967 cruzeiro = one trillionth of a U.S. cent in 1994, including a single-year record of 2,075.8 percent inflation.

Germany (1923) — The highest denomination of the German mark increased from 50,000 to 100,000,000,000,000 in a span of 15 months. A currency reform in 1923 helped stem hyperinflation and linked the value of the currency to the U.S. dollar.

Israel (1971-1985) — Inflation rose from 13 percent in 1971 to 111 percent in 1979, to 133 percent in 1980, 191 percent in 1983 and then to 445 percent in 1984, threatening to become a four-digit figure within a year or two. A 1985 currency reform, price freeze, and other measures finally stabilized the currency in 1986, reducing inflation to 19 percent for the year.

Yugoslavia (1989-1994) — The highest denomination in 1988 was 50,000 dinars inflating to 2,000,000 dinars in 1989. Five separate currency reforms in 1990, 1992, 1993, 1994 and 1995 finally brought inflation under control. The overall impact of hyperinflation: 1 novi dinar = 1 × 1027 ~ 1.3 × 1027 pre-1990 dinars. Yugoslavia’s rate of inflation hit 5 × 1015 percent cumulative inflation over the time period Oct. 1, 1993–Jan. 24, 1994.

The Affect on Residential Builders and Developers

The bond markets already anticipate higher inflation rates over the long-term. Recent rises in oil and other commodity prices are precursors to a more competitive and volatile environment. Devaluation of the U.S. dollar has already started and is impacting some commodity prices. Uncertainties primarily revolved around the speed of economic recovery, growth and employment rates in the U.S.

In all likelihood, residential builders and developers will face: 1) increasing inflation in the U.S., 2) devaluation of the dollar outside of the U.S., and 3) commodity price increases. All three will punish U.S.-centric firms operating in what is likely to be a slow-growth U.S. economy. 

1. Inflationary Pressure Increasing

The likelihood of the U.S. experiencing hyperinflation, defined by the International Accounting Standards Board as greater than 25 percent annually, is low. The likelihood the U.S. will experience inflation at a rate higher than our recent history is high. Roughly speaking, the United States has experienced annual inflation of less than 5 percent for essentially the past 30 years starting in the early 1980s (Exhibit 1.1). Prior to that point, the late ‘70s and early ‘80s, the country experienced much higher inflation than this level, and for several periods it approached or exceeded 10 percent.

From a current economic standpoint, all of the factors that are likely to cause inflation currently exist, and if they are not unwound in the next 12 to 36 months, the U.S. will enter a period of higher inflation. In fact, the quantitative easing policy is intended to create inflationary pressure to stave off the threat of economic stagnation defined as a very low growth rate of 1 percent or less. Policymakers at the Federal Reserve currently fear stagnation to a greater degree than they see future inflation as problematic.

Two examples of inflationary expectations can easily be found. First, a recent auction of inflation-adjusted securities sold at an anticipated negative return. This negative return is an overpayment for the face value of the security; like buying a $10 dollar bill for $11 dollars.

“The Treasury sold $10 billion of five-year Treasury Inflation Protected Securities at a negative yield for the first time at a U.S. debt auction as investors bet the Federal Reserve will be successful in sparking inflation,” according to an Oct. 25, 2010, Bloomberg report, “Treasury Draws Negative Yield for First Time During TIPS Sale”.

The buyers of these securities anticipate that the inflation adjustment mechanism of these bonds will be utilized in the future and result in higher interest payments. Essentially, investors expect to earn the negative return back with these higher interest payments over time. If inflation at higher rates does not come to pass, investors will simply have paid too much for these bonds.

The second is the credit-default swap market, where activity volumes have spiked since November 2010.

“Plenty of investors are concerned about the potential impact of the Federal Reserve’s monetary policies and inflationary pressures on Treasury bond yields,” according to a Feb. 1 article in The New York Times, a version of which is available here. “Treasury-related default swap contracts worth nearly $1.4 billion changed hands in the two weeks ended Jan. 21, according to the Depository Trust and Clearing Corporation — two-and-a-half times the average activity over the previous six months. The surge in activity points to an intensifying investor perception that the possibility of a government default can no longer be completely dismissed.”

The likelihood of U.S. default on existing debt is exceptionally remote, but the increase in trading activity in instruments that hedge against a potential default speaks to the shifting perceptions of the creditworthiness of the U.S. government.

2. U.S. Dollar Devaluation

As the value of the U.S. dollar falls in relation to other currencies, goods or services created outside the United States will cost more. Exhibit 1.4 displays the value of the U.S. dollar as measured in Euros. Since implementation of the quantitative easing policy took place Nov. 3, 2010, the U.S. currency has lost value in comparison to the Euro. The British Pound Sterling has followed a similar trajectory. Closer to home, the Brazilian Real and Canadian Dollar are also appreciating against the dollar, thereby eroding the purchasing power of the U.S. currency.

Overall, devaluation of the dollar makes U.S. exports more cost competitive and attractive. It also makes imports to the U.S. more expensive. Many construction commodities, particularly lumber, copper, oil and petrochemical products, are imported or internationally sourced through transactions denominated in dollars.

3. Commodity Price Increases

The quantitative easing policy will have an immediate effect on the cost of construction commodities. Oil, copper, and lumber are three examples that began increasing in cost during 2010 and have accelerated since November in part due to the change and anticipated change in the value of the dollar. In a January article, “Material Concerns: Commodity Prices Are Surging at a Very Early State of the Cycle”, The Economist pondered, “Given that the global recovery is at a very early stage, do high prices indicate that the world faces significant supply constraints, which will be a problem for years to come? Will such constraints lead to prolonged inflationary pressures and cause central banks to tighten monetary policy? Or are high prices simply a bubble, the result of speculative activity in the futures markets?”

Changes in commodity, material and equipment costs will obviously impact construction budgets. In the vast majority of cases, residential builders putting in place product over the previous two years have observed savings on construction spending related to lower commodity materials and equipment costs rather than lower labor costs. In Exhibit 1.5, the drop in lumber prices beginning in 2006 and the drop in steel and non-ferrous metal (copper, etc.) pricing since 2008 are obvious. Not shown in the chart: from the high point of pricing for steel, nonferrous metal and lumber around 2006 to the low point around 2009 or 2010, pricing declined in excess of 40 percent, 60 percent and 30 percent, respectively.

“Higher pricing may cause a surge in head line inflation but their main effect will be to act as a tax on consumers” of these commodities, according to the same article in The Economist. Home building, as one of the biggest consumers of various construction commodities, have benefited over the previous two to four years and will see these gains eroded through this “tax” over the coming 24-36 months through rising commodity prices. Home builders are unlikely to push some portion of this risk onto trade contractors or vendors as commodity prices are likely to be both highly variable and rise over the coming 24-36 months. Both lumber and non-ferrous metals such as copper are already experiencing increases in pricing that are anticipated to accelerate.

Conclusions

The old quip “a stitch in time saves nine” offers some insight into the window of opportunity facing U.S. residential builders and developers to plan for and mitigate the risks of U.S. inflation, devaluation of the U.S. dollar and commodity price increases.

With these certainties are a host of relative uncertainties associated with the policy of quantitative easing. Residential builders and developers will be forced to navigate these challenges and search for real opportunities.

While many observers have little faith that the Chinese governmental authorities have the best interests of the United States at heart, their perspectives on the quality of U.S. Government debt are relevant as they are currently the largest debt holder. The Chinese ratings agency, Dagong, scorned quantitative easing as “a practice resembling drinking poison to quench thirst … In essence the depreciation of the U.S. dollar adopted by the U.S. government indicates that its solvency is on the brink of collapse.” Federal reserve policy, industry regulation, financial and banking reform and, most importantly, a return to robust economic growth in the United States will all dictate whether the U.S. is consuming “poison” or nourishment.

All in all, the quantitative easing policy is complicated to explain, difficult to implement effectively, and speculative as there is only limited insight into the likelihood of the potential outcomes. Prudent home builders and developers should take action today and ensure they make a “stitch in time.”

Mark Bridgers is a principal with Continuum Advisory Group specializing in driving transformation of the home building and multi-family development and construction process. He can be reached at (919) 345-0403 or mbridgers@ContinuumAG.com.