How The Fed Is Taking A Bite Out Of Real Estate by Lesley Hensell For the fourth time since June, the Federal Reserve Board raised a key interest rate this week, thus putting in jeopardy the long-awaited gains real estate equities have racked up over the last few weeks. The Federal Open Market Committee raised its target for the federal funds rate by 25 basis points to 5 ¾ percent, while the Board of Governors approved a 25 basis point increase in the discount rate to 5 ¼ percent. "The Committee remains concerned that over time increases in demand will continue to exceed the growth in potential supply, even after taking account of the pronounced rise in productivity growth," explained a statement issued by the Fed. "Such trends could foster inflationary imbalances that would undermine the economy's record economic expansion." Further, the Fed waned that "the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future." Over the past months, this column has repeatedly railed on Fed Chairman Alan Greenspan and his pack of followers for seeing extraordinary inflationary pressures where, in truth, there is only a slight swell in upward price pressure. Until now, however, I have held onto my Greenspan faith. After all, more than any president, policy-maker or business leader, Greenspan can take credit for helping engineer the longest and most impressive economic expansion in U.S. history. But the quest to continue the expansion has created a gun-shy attitude within the Fed that now will begin to have a dramatic negative impact on the real estate sector. See, when the Fed raises interest rates, it is more expensive for companies to service their debt. This has a direct negative impact on corporate earnings, especially for companies that are closely related to the financial markets (i.e. financial services, real estate and capital-intensive companies). When rates go up, equity flees from these companies' issues and flows toward higher-risk, higher-possible-return investments that can beat the higher cost of capital, such as high-technology companies. Thus, when the Fed made its announcement, Blue Chips fell while the Nasdaq saw a respectable gain. Investors are pushing their way into these issues in hopes that these companies, which do not carry high capital investment costs as durable goods manufacturers and real estate companies do, will continue to grow earnings despite the increased cost of doing business. Unfortunately, the conventional wisdom among analysts holds that the Fed will take this same measure two more times before the end of June, pushing prices higher for consumers and businesses alike. So why all the fear at the Fed? In the last quarter of 1999, the economy grew at a hot 5.8 percent annualized rate. For the entire year, growth stood at 4 percent - far above the 2.5 percent that 1980s economists felt was safe. The U.S. unemployment rate has fallen to 4.1 percent, the lowest level in 30 years, leading to wage pressures as employers desperately seek help. Consumer prices, however, have not seen any significant increases, especially when the exaggerated oil and energy components are removed. The only conclusion that can be reached upon evaluating all of the facts is that Greenspan has lost his edge and become Wall Street's equivalent of Chicken Little. By ignoring the productivity and technological gains that allow a rate of growth higher than the standard 2.5 percent once accepted as "hot," Greenspan and his cronies are penalizing business and consumers for succeeding in an increasingly competitive global marketplace. The timing is particularly hurtful for publicly traded real estate companies who, because of their highly leveraged, landed investments are particularly sensitive to interest rate hikes. The capital that has recently flowed into the sector and boosted lagging stock prices now will be tempted away to industries less affected by the Fed. And as long as I'm being economically theoretical, I may as well float a wacky idea for your consideration. Could the Fed's actions actually by inflationary, rather than serving as a check against inflation? In the past, the Fed has hoped that increasing rates would result in fewer housing starts, less growth in consumer spending and lessened wage pressure. But the economy has shifted into a new state of being. Despite the Fed's fears, consumers are confident in an ever-improving future. Their spending is not subsiding substantially, despite the Fed's warnings. While new housing starts have slowed a bit, there has been no significant drop in sales. Therefore, consumers are spending at approximately the same rate, while paying higher debt-service costs. Isn't this behavior inflationary? In the same vein, businesses are being forced to pay higher wages to get quality employees on the payroll. As the economy rolls on, and orders for goods and services do anything but decrease, companies still will have to fund these new positions. They will be spending the same amount to hire new folks, again with higher debt-service charges. And again, the Fed creates its own brand of unnatural marketplace. Adam Smith (a.k.a. the invisible hand of the free marketplace) would not be happy. And neither should be the real estate industry. | 
