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Realities of Real Estate: The Federal Reserve System

Today, there are many factors that affect the health of our real estate markets. The generally poor state of the economy and persistently high unemployment have depressed home ownership rates to the lowest levels in 15 years.

With the recent downturn in real estate values, many home owners owe more on the mortgage than their house is worth, making it difficult, if not impossible, to sell their homes, essentially stagnating a portion of the market. And government programs designed to kick-start housing have proved to be limited and largely non-productive.

Nevertheless, the housing market has shown clear signs of improvement. To a large extent, this improvement is due to the self-correcting nature of the free market place. Despite the depth of the problem, and what external forces are employed to rectify the situation, the laws of supply and demand ultimately rebalance the system, bringing buyers and sellers back to equilibrium and stabilizing prices.

Throughout the process of recovery, there is one player that yields significant power, yet its function and how it works to impact real estate, as well as the economy as a whole, is somewhat mysterious to the average man on the street. We’re talking about the Federal Reserve. So, what exactly is the Federal Reserve, and how does it influence everything from gas prices to house prices to the stock market?

The Federal Reserve System was created by Congress in 1913 in response to the banking meltdown that began in 1907.

In the early part of the 20th century, the stock market was collapsing, resulting in a run on the banks. Our entire financial system was in turmoil, driving us toward the Great Depression. As a result, the Federal Reserve System was created to act as sort of a backstop for the banks.

If an economy is to weather tough financial times, it is necessary to maintain liquidity in the system. In other words, there must always be enough cash on hand to avoid panic and grease the wheels of our economic engine. When liquidity was insufficient to keep the ball rolling, the Federal Reserve System (commonly known as the Fed) could step in and generate the cash necessary to help restore equilibrium in the supply and demand of money.

The Fed has a number of ways to do this, and the economics can be fairly complex. But, in simplest terms, think of the Fed as a pressure relief valve. Largely through a manipulation of interest rates, it allows enough cash to build up in the system to provide for economic growth, but when necessary, it can also blow off steam to reduce the money supply.

It’s a delicate balancing act. Too little money and the economy will stall. Too much money and the excess cash will result in inflation, an equally burdensome problem for financial wellbeing.

Over the years, the Fed has taken an increasingly active role with respect to how it regulates the money supply. Many are skeptical of the power the Fed has assumed and whether or not its intervention has been productive. Here’s why.

First, the Fed is an independent body. The current chairman is Ben Bernanke; the chairman is appointed by the President, and approved by the Senate. The chairman normally survives changes in administration and the political patronage that goes along with that.

Bernanke was first appointed by President George W. Bush in 2006. The previous chairman, Alan Greenspan, survived the administration of four presidents. There’s both good and bad with that.

To our benefit, it attempts to eliminate politics and, hopefully, direct fiscal policy on the basis of non-partisan facts and figures. Conversely, the Fed makes enormous financial decisions, but it can act with impunity, leaving it vulnerable to the political leanings of a select few. The President, the Congress and even the Supreme Court have no control over Fed decisions.

Second, the scale of Fed’s control over our finances, and even that of the world economy is enormous. There might be much consternation over President Barack Obama’s $800 billion stimulus spending, but the Fed routinely makes policy decisions directing tens of trillions in and out of the economy.

For example, you may have heard about the Fed’s ruling to embark of something called QE3. Well, that’s not about a trip on a luxury ocean liner. QE stands for quantitative easing. Quantitative easing is when the Fed buys mortgage backed securities in an effort to keep interest rates low and flood the economy with cash.

In short, it’s like the government borrowing money from itself. The net result is to thwart the free market place and produce a temporary sense of faux prosperity, in hopes it will prime the pump for “legitimate” economic growth down the road. It’s called QE3, because we’ve already had QE1 and QE2, where trillions of dollars in made up money have failed to generate results.

Barely a month before a presidential election, Bernanke has come under fire for unleashing QE3 in an attempt to reinvigorate an economy, perhaps failing for leadership, rather than a lack of cash.

Third, the Fed is a body directed by individual human decisions. Heretofore, the success of our economy was based on the free enterprise system; whereby, the marketplace picked winners and losers, efficiently allocating limited financial resources toward those enterprises that best created the goods and services most in demand.

The arrogance of thinking that a few guys around a conference table can outsmart the entire economy has frequently resulted in a cycle of boom to bust. Free enterprise solutions often make for a smoother transition with respect to the ups and downs in our economy. With many Fed actions, it’s more like going from slamming on the brakes to stepping on the gas.

Now that we’re into the Fed’s third stab at quantitative easing, how does that translate into the economics of everyday life, and more specifically, real estate?

With QE3, the Fed will buy $40 billion in mortgage backed securities every month for an unspecified amount of time. On the positive side, that will keep mortgage rates low. But, there’s a price to be paid for this policy. When the Fed spends, it is currency created out of thin air, amounting to nothing more than the government printing money. As a result, it devalues the American dollar.

Oil is traded in U.S. dollars. So, when the value of dollars goes down, the price of oil goes up, and you pay more at the pump. Plus, since energy is a significant part of everything we buy, the additional cost will ripple through the economy, raising prices for everything you buy.

Additionally, when the Fed announced its adventure into QE3, we saw a spike in the stock market. Many might think this is a reaction to Fed policy, believing it will improve the economy. In reality, it’s a reaction to lower bond prices, resulting in a transition from bonds to stocks. It isn’t necessarily a recognition that Fed policy will actually improve the economy.

My mother always said she thought the whole world’s economy was controlled by a small group of people who pulled the strings. I always recoiled against that, telling her that in this country the economy is about individual effort and not individual control. Mom’s usually right, but in this case, I hope she got it wrong.

Bob and Donna McWilliams are practicing real estate agents in Maryland with more than 25 years of combined experience. Their email address is