Real estate markets, especially over the last few years, have had a fabulous run. And historically low interest rates, no doubt, have contributed greatly to the cause. But the 20-year slide in long-term rates - from 15 percent in the 1980s to 3 percent last year - seems to be over. How high and how fast rates will rise is the question.

ECONOMICS 101
The real estate market, like all free markets, is controlled by the forces of supply and demand. It is really quite simple: When buyers are more motivated than sellers, home prices rise; when sellers are more motivated than buyers, home prices fall. In the late 1980s, when IBM abandoned its Kingston facility, thousands of IBM workers found themselves without jobs or relocated. The result: homes for sale. The glut of supply, especially in Ulster County, caused a great imbalance in the market. Anxious sellers lowered their prices to entice buyers. It took years to work through the oversupply conditions, and home prices suffered. Recently, demand for homes, and as a result, home prices, in the Hudson Valley have been extremely strong. The most popularly cited reasons for this strength include the events of 9/11 scaring many NYC residents to safer ground; improvements in telecommuting that make working from remote locations possible; and second-home buyers searching for alternatives to the overcrowded Hamptons and metro area beaches. While these all have all been contributing factors, it is the historically low interest rates that have had the greatest impact on spurring real estate demand and skyrocketing home prices.

Long-term interest rates are controlled by market forces, and often reflect expectations for future economic growth and inflation. Short-term interest rates, however, are controlled more directly by the Federal Reserve Bank (Fed), the central bank of the U.S. government. In fact, the Fed, under the leadership of long-time chairman Alan Greenspan, carefully monitors the changing U.S. economy, and attempts, often successfully, to manage the peaks and valleys through the use of monetary policy. Think "Goldilocks" - the Fed wants our economy to grow at a sustainable, "just right" pace, neither too fast nor too slow. The Fed's chief tool in managing the economy is the federal funds rate (the overnight lending rate between banks), and they raise and lower this key short-term rate as a means to either stimulate or slow economic activity.

When the economy is in recession, as it was a few years ago, the Fed put its foot on the accelerator by lowering the fed funds rate, essentially making money cheaper. Lower short-term rates means banks pay less interest on savings deposits (less than 1 percent over the last year) and lend at lower interest rates. When you are receiving virtually no interest on your savings, you find something better to do with your money, either investing in higher-risk instruments (like stocks or real estate) or spending more. Individuals more readily borrow cheap money to make a new car purchase or renovate their home, and corporations invest in new plants, equipment, and technology. In contrast, when the economy is growing too fast, as it may be now, the Fed needs to put the brakes on to avoid inflation by raising the fed funds rate. Higher interest rates encourage saving: as short-term rates rise, more people are willing to leave their excess funds in the bank, which is paying more attractive rates on deposits. Individuals and corporations are less willing to borrow at higher interest rates to make new investments, and economic activity slows.

THE FED'S DILEMMA
In a battle to extricate the U.S. from its most recent economic recession, the Fed brought short-term rates to 46-year-low levels to encourage consumer and capital spending. Though the Fed clearly achieved its goal of re-accelerating the economy, they may have gone too far, and may have been too slow to reverse course. In a normal business cycle, as the economy begins showing strength, the Fed begins hiking rates (remember "Goldilocks") to prevent the economy from going too fast and bringing on inflation. In the current cycle, however, the Fed has been slow to raise short term interest rates because new job growth (a key measure of economic health) has been slow to develop.

Over the last few months, however, reports of strong job growth (about 900,000 new jobs over the last three months) and evidence of rising inflation pressures, coupled with the already healthy economy,have given the Fed all the reasons it needs to begin raising short-term interest rates. Wall Street consensus now believes that the Fed will begin raising the federal funds rate, now at 1 percent,at their June 29th meeting. Of course, by the time you are reading this piece, the Fed has already made its move, and very likely has not disappointed the prognosticators. After all, nobody likes a surprise. Regardless, it seems certain that the long decline in interest rates over the last two decades is over, and that rates are heading back toward more normal levels. Most believe that the Fed is beginning a process that will take short-term interest rates, over the next year or so,back to the 3 percent range. The Fed does not want to scare anyone, of course, and would like to bring rates back up in a slow and measured way. But here is the catch: If inflation worries become reality or the economy continues to pick up steam from here, the Fed may be forced to raise short-term rates higher and more quickly.