Monday, January 5, 2015

Where Will Yellen Take Land Values?

A few months ago I wrote about the then-current state of land values in Texas (and linked to a similar post about the Midwest) and the prospects for land values going forward. In that article, I noted that low interest rates over the past several years have lead to a massive run up in land values. Further, I indicated that careening crops prices didn't offer much help for land rents in the near future, indicating that land values will likely start to fall.

Since then, crops prices have moderated, at least a little bit, and the Federal Reserve Bank (the US Central Bank) dropped a veritable bombshell with its monetary policy statement back in mid-December. The bombshell was simply the removal of the phrase "considerable time" from its Federal Funds target rate projections. That may not sound like much, but it provided more than a shudder for financial markets.

Whenever the Fed makes a policy statement, markets react. This is because changes in the Federal Funds rate, and therefore interest rates throughout the economy, have big implications for asset markets. Simply put, if rates rise, the future cash flows from assets like land or stocks will be more heavily discounted and thus those assets are worth less today. If rates fall, the opposite happens. The December policy statement essentially indicates that the Fed believes that current economy-wide indicators like unemployment, business investment, and inflation are improving thanks to the previous stimulus provided by the Fed. Thus, the Fed can remove the stimulus of low rates and return to "normalcy."

However, many financial prognosticators (as well as myself) feel that this is a mistaken view. The stimulus provided by artificially-low interest rates has not created real, sustainable growth and, if removed, the recovery we've enjoyed over the last few years will dissipate. I'm not calling for a massive drop in GDP in 2015, but artificially low rates don't allow for efficient and sustainable allocations of resources. If interest rates are allowed to rise, some sort of correction will occur. Interest rates are prices and prices have important information in them. When those prices are distorted, they can't tell the proper story about preferences and resource allocations. A fuller treatment of this theory can be found here or a video here.

So when will the Fed allow rates to rise? I don't think it will be any time soon. The myriad economic indicators used to guide Fed policy will ultimately respond negatively when market participants expect a rise in interest rates, giving a justification for low rates and, perhaps, an even greater expansion of the Fed's balance sheet.

If and when rates rise, land values will likely take a substantial hit unless grains prices rise to the astronomical heights we saw over the last few years. As I indicated in the article back in October, rates will rise in the long run whether the Fed pushes them up or not. The only question is "How far away is the 'long run?'"

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