TCS Daily

What Is the Fed Doing on Housing?

By Desmond Lachman - November 2, 2006 12:00 AM

Some years ago, the late Rudi Dornbusch, the renowned MIT economist, famously said of the Bank of Mexico's board that he could understand it making policy mistakes. After all, the board members were only human. However, what he could not understand was the same people making the same mistakes time after time.

One has to wonder whether the same might not be said of the Federal Reserve Board as it presently hews to a stridently anti-inflation line at a time when the housing market bubble now shows every sign of deflating. What, if anything, did the Federal Reserve learn from its experience with the bursting of the earlier NASDAQ equity bubble in 2000? Might the Fed not have learnt, as is now acknowledged by most analysts, that it was far too slow and timid in reducing interest rates in response to the bursting of that bubble, as a result of which, not only did the US economy go into recession but it also flirted with deflation?

While the NASDAQ bubble burst in March 2000, it was as late as January 2001 that the Fed gingerly started cutting interest rates. And it was only after September 11, 2001 that the Fed aggressively began easing monetary policy. By the time the easing cycle had ended, the Fed found that it had to cut interest rates by as much as 550 basis points and take interest rates to a forty-year low of 1 percent in order to avert a deep recession.

Since 2000, housing prices adjusted for inflation have increased by a staggering 70 percent, or by an amount that has no precedent in the United States over the past 100 years. They have also risen in a way that cannot be explained by changed demographics or other underlying factors but rather must be explained by a prolonged period of an unusually accommodative monetary policy and by the increased use of exotic lending practices.

The spectacular run up in home prices has boosted household wealth by as much as 50 percentage points of disposable income or by an amount not very different from that created by the earlier NASDAQ bubble. This has provided important support to US economic growth over the past five years as the unanticipated increase in wealth has encouraged households to take on excessive debt obligations and to run down their savings to a dangerously negative level.

There are now ever-increasing signs that the housing bubble is beginning to deflate in response to the Fed having restored interest rates to more normal levels. Whereas house prices were still increasing at a 15 percent annual rate earlier this year, these prices are now falling. And yet the inventories of unsold houses has now risen to almost 7 months' supply as compared, with only 4 months' supply a year earlier. This must raise the real prospect that the deceleration in house prices in the period immediately ahead picks up pace.

Beyond the mounting inventory of unsold houses, the longer-term outlook for housing prices is clouded by a number of negative factors. Among the more important of these is the fact that around US$1 trillion in adjustable rate mortgages that earlier fueled the housing boom are due to reset in 2007 at significantly higher rates. At the same time, large speculative positions in the housing market are being unwound, additional supply from past investment decisions continues to flood the market, and the bank regulators are now beginning to tighten bank mortgage lending standards at precisely the time when the housing market is already weakening.

In the same way as rising home prices significantly boosted US economic growth over the past five years, declining home prices must be expected to substantially subtract from growth in the period immediately ahead. The direct effect of a slower pace of residential construction could very easily shave off a full percentage point from GDP growth. More troubling still is the indirect impact that falling home prices could have on growth. With the savings rate now at negative levels and household debt levels at an unprecedented high, households must be expected to attempt to significantly reconstitute their savings in reaction to a decline in their asset position.

With the very real prospect of a cooling US economy in train, it is difficult to understand why the Fed is now still fretting about inflationary pressures. It is all the more difficult to understand the Fed's backward-looking approach to inflation when one considers that the unwinding of the last five years' run-up in home prices is likely to be a drawn out process that will constitute a significant drag on the US economy for a number of years.

One would have hoped that the Fed would have learnt more from its slow response to the bursting of the NASDAQ bubble. However, sadly, all the clues seem to be pointing in the direction of the Fed being little different from Rudi Dornbusch's characterization of the Bank of Mexico of old.

The author is resident fellow at the American Enterprise Institute.



Why should the Fed do anything?
Why should a "free enterprise" outfit be advocating that the Fed do anything?

Is it the govt's job to bail out people who gamble by buying more house than they can afford? The tone of the essay indicates that houses belong to the people making the payments when, in fact, they are owned by mortgage companies just as most as the new cars on the road are owned by loan companies.

Second, as long as wealth is measured in money then only money "counts." The potential sales value is interesting but of no value utill sold. Ask the people who only bought ENRON. They all had potential wealth but only the people who sold in time actualized their potential wealth.

Now that most every investor - every bank official has computer access it is foolish to let the Fed set the rates. The loan rates to the member banks should be bid just as the bond rates are.

The Fed's still behind the curve
What this author seems not to understand is that the so-called housing "bubble" was the product of the Fed's excessively easy monetary policy, which has seen core inflation jump from about 1% to 3% in the last three years. The deflation of the boom is the inevitable consequence of the Fed moving back toward more normal rates, but in fact the Fed has more to do to reach monetary equilibrium. At some point fairly soon, the Fed will be compelled to start raising rates again because there's still too much liquidity in the system to avoid seeing inflation continue to push higher. There is likely significant sentiment at the Fed that's pretty much in tune with this author's concerns about the broader effect of a housing downturn. That's why they prematurely stopped the rate-hiking process in August, and it's why they're probably going to remain on hold as long as possible before resuming rate hikes. But when push comes to shove, they'll have no choice but to respond to the persistence of an unacceptable inflation uptrend.

The job of the Fed
Is to maintain a steady value for currency.

If the housing market is collapsing, that is evidence that the Fed applied the breaks too hard.

A MARKET Based FED Policy
The Prime rate is currently 8.25%. Long term bonds are currently at about 5%. If the market believed inflation were a long term concern, why would yields on long term bonds be so low? When it comes to inflation, I choose to believe the market. Under “normal” conditions, the FED should set its discount rate so the Prime rate is close to the market rate of long term securities. The current 3% difference is not “normal”…it indicates that the FED believes inflation is an imminent and extreme danger. There is no data to support this radical belief. The FED has overreacted 3 times in the last decade...and many times before that. A FED policy pegged to market conditions would work as follows:
1) Inflation within target range: Funds rate = long bond rate -3% + .5%
2) Inflation below target range: Funds rate = long bond rate -3% + .5% - recession adjustment
3) Inflation above target range: Funds rate = long bond rate -3% + .5% +inflation adjustment

A policy of “pegging” the funds rate to market rates depending on inflation performance is stable and predictable, while still allowing the FED flexibility. Based on the above, the current Funds rate should be: 5% - 3% +.5% +1% (for inflation above target) = 3.5%. Because the FED has raised rates 1.75% above this level, they have been and remain in an aggressive inflation fighting stance. Since this stance is not justified by the facts, it is very likely that the next couple of years will feature anemic growth at best. I just hope the next FED move is not yet another overreaction.

The Fed is always behind the curve
Inflation is a lagging indicator, and monetary policy also has a time lag before it takes effect. So if your policy depends on waiting until you see inflation increasing or decreasing and your policy has an approximately two year lag time you will always over-control and swing wildly between boom and bust. Think about driving a car or flying a plane with a thirty second delay between moving the controls and having anything happen. Good luck staying on the road or in the air.

then it is unnecessary
Then the Fed is unnecessary. The international money market controls the value of the dollar.

As I recall, when I was a kid in the 50's pass book savings paid 3%-4% and mortgages were 4%-5%. Bankers were getting rich on a 1% differential.

only indirectly
The fed controls the value of the dollar by controlling the number of dollars in circulation. Pump more dollars into the system, and the currency markets will reflect this by pushing down the value of the dollar.

Fed can't force people to borrow
The Fed can only put money into circulation by lowering the interest rate. I create new money and put it into circulation by using a credit card.

Steady as she goes...
We are exactly where we want to be. Yes we (private household entities) made a lot of money on the housing run up. And yes this was enhanced by cheap mortgages. We may not be able to cash out of our homes during the next couple of years quite as quickly as we did during the past couple of years. So we'll hold on. Unemployment is very low and wages just ticked up. So we can probably pay our mortgages. If anyone gets so cash-strapped that something must go then it will be those unsecured credit card debt payments. The banks will suffer significant defaults long before people will let their homes get foreclosed.

We can tolerate a certain amount of downward correction in home values because those projected values we enjoyed for a moment were of recent vintage and they were only paper profits like lots of assets in our portfolios that move up and down. Our stocks are probably doing just fine. Any of us who went long and deep on oil or gold are losing more there than our home values might decline. (And who told us that high oil prices were consistent with supply and demand fundamentals? The financial journalists. Morons.)

The Fed will be urged to increase the overnight rate a bit more to fight inflation generated by the current flattening of productivity gains combined with wage rate increases. Alternatively the Fed will be urged to decrease the overnight somewhat to juice up the housing market again.

The Fed will sit tight. Inflation is fine today and even 4% would not kill us like everyone seems to think. Housing is solid, correcting and thankfully the run up is over. Oil has been correcting for a while already and the stock market is healthy.

Many of the small companies started in this decade (using the equity suddenly available in our houses as startup capital) are now profitable and growing. The Baby Boomers who were ready to retire already sold the family home at a hefty profit. The younger generation bought into the housing market, they have jobs, and they are settling into their productive years.

Our consumer economy is solid and the crazy spending of the late 90's was not really such a big deal during the last couple of years. People knew they had more money but they were not so foolish as to believe that the Old Economy fundamentals could be violated.

Some speculators who bet that the home value run would continue until they could liquidate will get caught short and some might get foreclosed. Tough. That's why they call it gambling. But this is not the stagflation nightmare of the Carter years. Mortgage rates are not going to 18%.

The Fed did perfect. All this correction will settle into a soft landing in the 1st Quarter and a more sustainable expansion as our companies continue to exploit global opportunites. Rememeber. Americans are not creating much wealth ourselves through manufacturing anymore. We are all living off the hard work of cheap labor in the developing world. That process is going forward. We're fine.

The Realities of FED Funds Policies
"Bankers were getting rich on a 1% differential."

1) In recent times the 3% differential between the Fed discount rate and the Prime rate has been nearly uniform. 2) R/E based variable-equity-loan rates tend to be close to the prime rate.
3) Fixed R/E based mortgages rates are a different market, and do not follow as closely the funds rate changes.
4) Large CD rates tend to be very close to the Fed funds rate.

The result is that the FED and the banking system are a government established Cartel that largely controls interest rates in the US. By implementing a more market based approach, the FED can better serve ALL of their stakeholders.

Fed doesn't have to force people to borrow.
People are always looking to borrow. By making more money available to borrow, they reduce the price borrowers must pay to get some. IE, they cause the interest rates to come down.

sucker born every minute
Agree. The majority of the borrowers who use credit to buy toys, new cars, and 4000 sq ft houses will screwed when the stuff eventually hits the fan. Breaks my heart.

credit cards
These days are not most banks making most of their money on credit card balances?

Not all loans are for consumer goods.
And the majority of them are for rates so far above what we are talking about that there is little connection between them.

I'm talking about mortgages, I'm talking about business loans. Do you also think that such loans are inherently evil?

The Fed on Housing
Question to the writer of this article: Can you please explain to the American people, if you know, what Freddie Mac and Fannie Mae are etc., etc.,etc.? I bet that most people who wrote in don't have a clue what they are!

Pre-Emptive Fed Action
The Fed should have raised rates much sooner and kept the bubble from getting to the level it's gotten to.

Instead, they waited and went slowly when they did start raising rates. In addition, Greenspan, and later Bernanke continued to deny the existence of a bubble, to help keep the bubble going. Even now, Greenspan is out claiming the housing crash has hit bottom. Talk about pure propaganda.

One of the jobs of the Fed to accurately and honestly inform the public, not to propaganize to perpetuate bubbles for the profit of investors.


loans and mortgages
Business loans must be analyzed on an individual basis. After WW2 people were happy to get a 1000 sq ft house and rule of thumb was that a house payment should be less than 25% of take home pay. Now days people with a 1000 sq ft house think they need a 4000 sq ft house with a 500 sq ft garage for the new cars they are making payments on and they are paying more than half the take home from 2 incomes. Yes, this is stupid if not evil.

TCS Daily Archives