Alan Greenspan and Bad Statistics

In a Wall Street Journal editorial earlier this week, Alan Greenspan categorically denied any complicity on the part of the Fed in the run-up of housing prices between 2002 and 2006.

Accelerating the path of monetary tightening that the Fed pursued in 2004-2005
could not have "prevented" the housing bubble.

While the Fed may have failed in its role as prudential regulator and may, through that channel, have contributed, I completely agree with Greenspan: the monetary policy stance of the Fed was not at fault. Greenspan attributes the run up to home mortgage rates rather than to “easy money” policies on the part of the Fed.

There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

At first glance, Greenspan seems to be quibbling over subtle changes in the term structure. After all, the Fed implements monetary policy through control of the shortest end of the yield curve. Indeed, over at least part of this time period in question, the Fed was actively trying to influence the long end of the curve through its monetary policy statements: recall the language such as “measured pace” in the statements.

Greenspan, however, is clearly aware of these issues and instead sites a fall in the correlation between the Fed Funds rates and mortgage interest rates as an explanation. He states

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

The picture below shows the Fed Funds rate and the 30-year mortgage rate from 1974 through February 2009. On average, the two rates do indeed move closely together—arbitrage arguments limit the differences between the two rates. The long-term average hides frequent deviations in the two series. The spread between the two rates increased sharply in 1974, 1992, and 2002.
Greenspan uses the correlation in the two rates as his proxy for the efficacy of monetary policy. He notes that the correlation between the two series dropped sharply over the three-year period between 2002 and 2005. It’s true: the correlation was abnormally low.

But, the fall in the correlation was neither unique nor was it long-lasting. The picture below shows the three-year backward-looking correlation between the Fed Funds rate and the 30-year mortgage rate. The correlation bounced immediately back to its 2002 level and the average correlation between 2004 and 2009 was only a shade below the average from 1974 to 2002. The temporary change in the correlation does not appear to have been caused by the shift in global savings patterns—else it would have remained low. The correlation was actually at its lowest point in the late 1990s.

Moreover, Greenspan is careful, throughout his editorial to refer to long-term mortgage rates. He avoids mentioning ARMs in their entirety. Over this period, the number of ARMs issued was at an historic high. And, the fall in correlation, as shown in the picture below, is not evident between ARM rates and the Fed Funds rate. The increase in the Fed Funds rate seems to have pushed up the ARM rate.

Greenspan is famous for knowing data inside and out. He knows these numbers; I don’t know why he would misuse them. And, he is misusing statistics to make a case that need not be made. The Taylor rule is descriptive not proscriptive. Only a foolish central bank would implement policy with the rule. It is a useful guide for understanding central banks and their actions, nothing more.