Monetary Policy and the Housing Bubble

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>   (email exchange)
>   On Tue, Dec 29, 2009 at 8:55 AM, wrote:
>   Do you agree with their conclusion that monetary policy (low rates) didn’t affect housing
>   prices?

Yes, seems that way to me, too.

>   I guess they did raise rates from 2003-06.
>   Seems the very low short rates DID contribute to the ability to buy “more house” or qualify for
>   any house.

Maybe some.

>   For me it was the bush 2003 fiscal adjustment- spending increases, retro tax cuts, etc. that got
>   the deficit up to 200 billion by q303 which was about 8% of gdp annual. Then after a few years
>   the sub prime housing fraud started with loan officers on commission pushing fraudulent
>   appraisals and fraudulent income statements that turned the recovery into a mini boom that
>   actually didn’t get all that large before it crashed when the $trillion fraud was discovered.

Fed: “Monetary Policy and the Housing Bubble”

Our findings are both clear and limited in scope.

We find little evidence that the setting of U.S. monetary policy could have directly accounted for a substantial share of the strength in U.S. housing markets between 2003 and 2006. In particular, the rise in house prices or housing activity during this period was much faster than the pace consistent with the overall macroeconomic environment at that time.

But we also find that housing-specific developments were unusual in this period—and not only with respect to prices and activity. The form of mortgage finance—the prevalence and nature of mortgages with adjustable rates versus fixed rates, the role of other “new” or exotic mortgage features, and the role of different types of lenders and securitization paths—all shifted during this period. These shifts undoubtedly fed on each other, with strong demand for housing and rising house prices spurring unsustainable evolution in the nature and perceived risks associated with mortgage innovations and vice versa. This finding is quite limited in that it describes developments but does not explain why such developments occurred.

Nonetheless, our clear finding that traditional channels of monetary policy accounted for little of the rise in housing markets and that housing-specific factors involved the interaction of shifts in demand and mortgage finance suggest two important lessons for policy and certainly for subsequent research. In particular, our discussion connects to the questions of whether monetary policy should “lean against the wind” in the face of asset price bubbles and of how complimentary financial policies (for example, macroprudential regulation) may interact with monetary policy.”


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24 Responses to Monetary Policy and the Housing Bubble

  1. warren mosler says:

    the idea that asset bubbles are the realm of regulation may be telling us they won’t hike rates for that reason until other methods of controlling what they call ‘bubble’s are tried. Hence, rate hikes will be based entirely on their dual mandate of price stability and full employment while markets have been discounting hiking for asset bubbles?


  2. Ape Man says:

    My reading of this is that the Fed is trying to say “this was primarily a regulatory failure” without coming out and saying so.

    A question occurs to me when reading this, actually… Is there a possibility that the concept of a “ratings agency” is just flawed?

    You have commercial banking, which is theoretically concerned with pricing default risk on specific loans to consumers and businesses.

    Then you have another layer of abstraction on top of that, which is concerned with pricing risk on big groups of securities. Doesn’t that extra layer introduce an exponentially greater chance of error?

    Perhaps this is old ground covered by Taleb or someone, but for whatever reason this hadn’t occurred to me until I red the Fed’s bit about “investor appetite” being very high for the MBS’s.


  3. Blissex says:

    «We find little evidence that the setting of U.S. monetary policy could have directly accounted for a substantial share of the strength in U.S. housing markets between 2003 and 2006. In particular, the rise in house prices or housing activity during this period was much faster than the pace consistent with the overall macroeconomic environment at that time.»

    That sounds like crazy — because this is an interconnected world, and “U.S. monetary policy” is just one of the actors. What about Japanese monetary policy, their ZIRP and the yen carry trade?

    Also note the weasely “directly” qualification.

    So what if the USA (and the UK, spanish, etc.) central bank stood by and cheered when the Japanese one flooded large international markets with credit?
    USA monetary policy was to let that happen and drive up stock prices, and when that bubble burst the USA monetary policy became ZIRP too, and that 5% monimal interest rates were still deeply negative in real terms, and in particular in terms of asset inflation (if asset inflation is 10-20% per year, 5% per year interest rates are still very negative).


  4. JKH says:

    This is a surprisingly good article on excess reserves, term deposits, etc. from the Economist. It looks like they’ve been talking with someone from MMT.

    By contract, Econbrowser triple bogeys, as usual. He’s got some weird fixation that excess bank reserves are a prelude to currency issuance, among other errors.


  5. floccina says:

    Also according to Ed Glassier, at first the fall in interest rate pushed up prices in ares that restrict building areas. He said the payments on existing homes in anti-growth Boston MA, remained the same despite the fall in interest rates. After a while home prices started to go up simply because they had recently gone up and that is my definition of a bubble.


  6. Matt Franko says:

    From the fiscal side, I remember in late 03 into 04, an architect customer/friend of mine (residential) was putting some bids out and was suddenly getting back double+ the material cost from what he estimated for his clients. He contacted his person at a larger lumber yard in our area and was told that military construction contractors were buying all they could from the mills for shipment to the warzone after the end of major hostilities. It was causing lumber shortages in our local area (east coast mid-atlantic). I remember a 4×8 sheet of plywood nearly tripled in price in a short period. I think all of the facilities/const. contracts were Cost Plus Fee type arrangements so the contractors could probably just pass on whatever price they paid for materials. This might have helped to get prices rolling also.


    Jill K Reply:

    “I think all of the facilities/const. contracts were Cost Plus Fee type arrangements so the contractors could probably just pass on whatever price they paid for materials. This might have helped to get prices rolling also.”

    From 2000 to 2003, construction costs easily came in as budgeted. Then cost of lumber began to climb faster than we could build.

    Never thought about that until now. Excellent point!


  7. JKH says:

    One would expect the Fed to write a defence of its policy. And it’s reasonable to the degree that the problem was more complex than just the Fed funds rate.

    But what’s missing in my view is acknowledgement of some very strong correlation between the level of the Fed funds rate and the explosion in adjustable rate mortgage marketing. There was a very significant element of interest risk at the origin of this recession – but a particular type of interest rate risk due to the resets on these teaser mortgage rates. And it was the level of the Fed funds rate that was instrumental in luring people into this particular risk.

    I can’t find where the paper talks about that kind of correlation, except:

    “As a consequence, monetary policy during this period may have contributed to the rise in ARM usage to a degree that is not well captured by the statistical model we consider (or the degree implicit in our earlier macroeconomic analysis).”

    That risk wasn’t embedded as a factor in the Taylor rule, and it was a significant risk.

    Looks like Taylor is the Fed’s own version of the rating agencies.


    Tom Hickey Reply:

    And, lest we forget, Allan Greenpan thought at the time that ARM’s were a great idea and publicly said so. Regulatory forbearance is one thing, encouraging excess is another. At the height of the bubble, exotic loans accounted for 72% of the mortgages in Santa Rosa and 79% in Vallejo. Since then, Vallejo itself has gone bankrupt.


    JKH Reply:



    JKH Reply:

    I always thought that Greenspan’s greatest transgressions were in his cheer leading tendencies, rather than in his monetary policy per se. I’d include his own irrational exuberance for the “new economy” tech bubble in this category.


    winterspeak Reply:

    JKH: This is an important point. As monetary policy in general is a very weak channel, but thought of as being important, it means that the Fed’s regulatory function (largely rhetorical) on the capital side is more important than what they decide to set the FFR at.

    Greenspan was TERRIBLE at this, and I think he has lost his title of Maestro. History will not be kind to him.

    I don’t think asset bubbles are as problematic as credit bubbles, so I actually give him a pass on the internet craze.

    JKH Reply:

    I hear you; although there were interdependent interconnections involved in regulatory oversight as well – e.g. the SEC with non-banks. The US has to fix its regulatory balkanization.

    I think it’s a character flaw with him as much as a policy error – sort of like putting your crazy uncle in charge of the financial universe. I didn’t like his interpretation that his “beliefs betrayed him” or something to that effect, about the world crashing about him as a result of the failure of rational expectations or something. That’s really crazy. Like Clinton with “it depends what the meaning of is is”, although Clinton’s probably more clever and clear thinking than Greenspan.

    Matt Franko Reply:

    Perhaps never put a personal friend and devotee of Ayn Rand in any regulatory position….

    winterspeak Reply:

    The notion that you can somehow create good policy independent of good people is probably one of the most damaging ideas in how democracies, modern or ancient, can be run.

    Mike S Reply:

    I agree on his cheerleading being his worst trait.

    But a second and very bad trait of his was to use monetary policy as both a political tool and a way of supporting asset prices, but never to deflate them.

    Look at his policy – and statements – during the Clinton years vs. the Bush I and II years. Lots of politically motivated stuff on both the statement and policy side.

    He is just another guy who was in the right place at the right time, not that great at all.

    And winterspeak, I agree fully. Our business/finance society is moving to fully embracing the capitalist ideal of no morals but that which makes money, which is going to force individuals to do the same. It is not surprising to me that our last bubble was predicated on nothing but slightly larger housing stock and trading, and not revolutionary technology like railroads, phones, electricity, computers, or the internet.

    When you have businesses focusing on money exclusively, only money will be “manufactured”.

    floccina Reply:

    ARMs are not a problem and can make good sense as long they are accompanied by a sufficient down payment and the payment is well within the means the of the buyer even in the case if rates rise the maximum for a couple of years. If they rise the maximum for more than a few years it is probably an inflationary period and so people should be earning more.

    IMO the worst thing Alan Greenspan did was to talk positively about the wealth effect based on taking second mortgages on homes that had risen in price. Greenspan was very pro Iraq war and I wonder if he saw the foolishness in what he said but wanted to keep things going in order to buy support for Bush and his war.


    warren mosler Reply:

    even with adjustables and teasers borrowers need qualify at the higher rates. much of the problem was fraudulent income statements from fraudulent accountants used by mortgage bankers and loan officers working on commission.


    JKH Reply:

    Agreed, although I think ARM proliferation was an important spark igniting the fraud expansion and the ultimate conflagration.


  8. Jim Baird says:

    The low rates were the spark that set off the brushfire. Securitization, low- or no- downpayments, and no-doc loans had been developing for 30 years before that. The sudden increase in values that the low rates made possible (all the lower rates did on the buyer’s side was bid up prices so that they were paying the same monthly payment rfor a larger loan) caused the whole machinery to kick into overdrive, and when it bagan to loose steam, exotic loans and fraud kept it going until the payments couldn’t be sustained anymore.


    Curious Reply:

    Since the natural rate of interest is zero, lowering interest rates to zero can only unrestrict economic activity into its natural state.

    Therefore, it was not the low interest rates, but the subsequent rise in interest rates, that caused the crises. Am I mistaken here?


    Jill K Reply:

    “.. no-doc loans had been developing for 30 years before that.”

    Yep, “hard money” lenders tested the water in the late 70s. Early to mid 80s Downey S&L pioneered COFI Arms as a portfolio product (not Agency sponsored) that adjusted every 6 months w/ 1.5 to 2% margins. Downey also was one of the first to offer low or no income document. It wasn’t called “stated”… it was called something else… oh bother!

    Anyway, they were referred to as “portfolio” product being that they stayed with the originating lender after closing. These loans performed perfectly every time.

    Is it any wonder why? Talk about blinding flash of the obvious!

    Lke Warren says – lenders should be required to hold on to the loans they originate. I’m convinced it’s the only way around this mess for good.


  9. Tom Hickey says:

    Here’s a comment I posted over at Karl Denninger’s place today that speaks to this issue. Karl was discussing the predominant role of fraud in the crisis:

    The kicker is “exotic loans.” The financial cycle could not have progressed to late-stage Ponzi finance (in Minsky’s sense) if it were not for these “exotic” arrangements and lack of due diligence in investigating loan applications. The problem was not with “isolated individuals,” but with the entire FIRE sector, which was colluding on the predatory practices that were the real foundation of the Ponzi finance that is continuing because if it stops, the game is up and we spin off into debt deflation, in which excess leverage is amplified by derivatives, and plunge into Great Depression II, which is the worst nightmare of Geithner, Summers, and Bernanke at this point. The US and world aren’t out of the woods yet, and there will be no major reforms or investigations while we are still very much on the edge of catastrophe (See Steve Keen and Michael Hudson on the debt bomb).

    Here’s a more detailed version I posted as Ian Welch’s place:

    The US and world are in the late-stage of a financial cycle, which as Hyman Minsky observed, is dominated by Ponzi finance. Compounding this in the present period is securitization based on consumer credit. A lot of derivatives (MBS, CDO’s) are based on leveraging consumer credit. This is a time bomb that the authorities realize can explode into the type of debt deflation that Irving Fisher originally described and which can still easily lead to Great Depression II if the house of cards crumbles. To put it bluntly, the failure of Bear and then Lehman woke the powers that be up to the fact that Merrill, Morgan Stanley and Goldman were next in line, with Citibank also deeply insolvent, and CDS’s spread all around that couldn’t be backed. As a result, emergency operations were undertaken to stabilize the system first and then to reflate the toxic debt as the only way out.

    It seems to me that the way to account for present policy is the fear that liquidation of any sort would likely blow up the system, which is still a house of cards resting on securitization of consumer debt. This fuse is still burning and the Fed and Treasury are trying to pour water on it with low rates, increased liquidity, and a blind eye to regulation and oversight. It’s anyone’s guess whether this is going to work, and if it doesn’t, then the world is in deep doo-doo.


    Dave Begotka Reply:

    Deep do do with nowhere to hide! Like a run away train down a hill all you can do is blow the horn.


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