A longer perspective.

Author:Berson, David W.
Position:Economic forecast for the 1990s - Cover Story

A Longer Perspective

Long-term interest rates should decline by about 350 basis points in the 1990s compared to their average during the last decade. That's the outlook by Fannie Mae's chief economist.

The outlook for 1991 is dependent in large part on events in the Middle East. Because economists have no comparative advantage in forecasting military or political events, the outlook carries with it a higher degree of uncertainty than usual. But in general, Fannie Mae's outlook for the economy and the housing market in 1991 is similar to the forecast presented by Lyle Gramley, chief economist of the Mortgage Bankers Association.

The long-term outlook is yet another matter that carries its own degree of uncertainty. We will attempt to sort out some of the factors that will shape the economy in the years ahead.

The near-term outlook

We have made the assumption that the conflict in the Middle East will be resolved in the first quarter of 1991, either through negotiations or a quick and successful war. The impact on the U.S. economy should be similar in either case, although even a successful war carries risks for the short-term production and distribution of crude oil from the entire Gulf region. If events in the Middle East actually unfold in this manner, then oil prices should fall sharply during the first half of next year, sliding to $21-$23 per barrel by mid-year. This should also push the overall rate of inflation down abruptly from current levels.

The economy is likely to begin this year in the same fashion that it ended the last one--in a mild recession. The combination of lower inflation and reduced borrowing demands will allow long-term interest rates to decline. In addition, with the economy contracting, the Federal Reserve should continue easing monetary policy, pushing short-term rates down. The decline in rates will be constrained, however, for several reasons.

First, high real interest rates abroad and the continuing need for foreign financing of our budget deficit will keep domestic interest rates from falling quickly or far. Second, despite lower overall inflation in the first half of 1991, a mild recession is not likely to create enough slack in the economy to bring the "core" rate of inflation down appreciably--and that will help to prop up long-term rates and keep the Fed from easing dramatically. Finally, unless the economy is weaker than we expect, the Fed will probably not ease aggressively for fear that the dollar would drop precipitously. The weak economy should allow rates to fall through mid-year, with long-term rates declining by about 50 basis points from late-1990 levels--putting 30-year fixed-rate mortgages around 9.50 percent--and short-term rates dropping by a bit more.

The primary reason for the current mild recession--the collapse of consumer confidence stemming from the Iraqi invasion of Kuwait--should begin to be reversed with a resolution of that conflict. Although lower mortgage rates will help the housing market, the current slow housing market has not been caused by excessively high mortgage rates. As a result, a significant rise in home sales and construction is not likely to occur unless potential buyers are more confident about their future employment and income prospects--which is unlikely to occur without a favorable resolution to the crisis in the Middle East.

This rise in consumer sentiment, combined with lower interest rates, is expected to allow the housing market to begin recovering by the second quarter. Home sales should recover first--with new home sales climbing to about a 585,000 annual rate by the fourth quarter and existing home sales going up to 3.42 million units. For the year as a whole, home sales should be close to their 1990 levels. Builders are likely to lag the increase in sales, however, particularly for multifamily structures. Difficulties in financing multifamily projects, combined with still-high vacancy rates, will keep multifamily construction in the dumps for at least the year ahead.

Single-family construction is...

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