By David F. Seiders. The housing sector may not be as hyper-sensitive to interest rate developments as in the bad old days when government-imposed ceilings on both deposit rates and mortgage rates controlled the flow of credit to this sector. But it's perfectly clear that interest rates still are critical to the health of the housing market. Indeed, the downward flexibility of mortgage rates pulled our fat out of the fire during the recession of 2001, and falling rates have kept housing healthy during 2002 in the face of a hesitant economic recovery and a collapsing stock market.

Firm hold

This also means that our central bank, the Federal Reserve, still has a rather firm hold on the interest-sensitive housing sector. While the Fed directly controls only very short-term interest rates, namely the federal funds rate which relates to overnight loans among banks, Fed policies work through the reserve positions of depository institutions and alter the volume and terms of credit throughout the economy. And while long-term market rates seem more free-spirited than in the old days, Fed policies (and market expectations of Fed policies) still influence the entire structure of interest rates.

It's worth remembering that the Fed tightened policy aggressively during the first half of 2000 and that the housing sector began to weaken right on cue. But then both the Fed and the financial markets detected serious weakening in housing and other sectors, prompting a sharp decline in long-term rates in late 2000 and a shift in Fed policy at the start of 2001. The Fed then embarked on a process of monetary ease that dropped short-term rates by nearly 5 percentage points during 2001 and ushered mortgage rates down to about 7 percent in the process. There's no question that these rate developments gave housing a second wind and kept home sales and housing starts up during the recession, even in the wake of the terrorist attacks of September 11.

Steady policy

The Fed has held monetary policy steady since the end of last year, but longer-term interest rates have shifted down dramatically anyway, pushing the mortgage rate to 6 percent by late September of this year. That's primarily because massive amounts of investment capital have fled the beleaguered stock market for the safe haven of fixed-income markets where credit quality is backed by the strength of the federal government. That means not only the Treasury markets but also the markets for securities issued or guaranteed by federal agencies or government-sponsored enterprises. The presence of FHA, VA, Ginnie Mae, Fannie Mae, and Freddie Mac in the nation's primary and secondary mortgage markets has helped keep mortgage rates in reasonably close alignment with long-term Treasury yields at a time when the financial markets have been preoccupied with credit quality issues and have shunned many other types of borrowers.

Shock absorber

The Federal Reserve and the mortgage-related securities markets should be able to absorb further shocks to housing and the economy during the uncertain period that lies ahead. The Fed still has enough monetary ammo left to fend off most unanticipated threats to the expansion, and strong links between the Treasury and mortgage markets should keep mortgage borrows in a favored class. The NAHB is forecasting stable or rising interest rates as the economic expansion proceeds, but it's nice to know that the interest rate shock absorber is there if we need it.