Monetary Policy and House Prices: Interest Rates and Timing

“The beginning of the run-up in housing prices predates the period of highly accommodative monetary policy.”  Bernanke January 2010

“Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.  This conclusion has been reached using both econometric models and purely statistical analyses that make no use of economic theory.”  Bernanke 2010

At the AEA meetings earlier this month Chairman Bernanke gave a speech disputing the Fed’s role in the recent sharp rise in housing prices.  His arguments ran along three key lines:  the timing of policy accommodation and the run-up in house prices do not match, models of interest rates and house prices imply little or no relationship between the two variables, and the international relationship between house prices and interest rates is inconclusive.  The last point I addressed in a previous post (here).  In this post, I will address the first two points. 

Timing

On timing, Bernanke’s main defense is that the beginning of the run-up occurred well before monetary policy became especially accommodative.  While house prices did start to rise in the late 1990s, house price appreciation accelerated sharply in late 2001.  The cumulative rise up to that point was consistent with previous U.S. house price cycles. 

The graph below shows 5-year cumulative real house price appreciation between 1980 and 2009.  The price series is the FHFA house price index deflated by the CPI.  On this basis, house prices began to increase in 1997.  That is in real terms in 1997, real house prices had finally recovered to their 1992 levels.  Between 1995 and 2000, house prices increased slightly more than 10 percent, or an average increase of about 2 percent per year.  High growth but no bubble. 

The Fed began its easing cycle in early 2001.  By the end of that year, the Fed funds rate breached 2 percent, hitting its lowest level since 1960.  By any measure, monetary policy was loose.  But policy was especially loose when compared to the advice given by a Taylor Rule.  Take a look at this picture from Bernanke’s speech.  Whether using backwards looking data or real-time forecasts, the Taylor Rule indicates an increase in policy rates by the end of 2001.  Appropriately, the Fed lowered interest rates substantially following the attacks of 9/11.  The Fed was responding to risks posed by the attacks rather than to incoming economic data. 

The timing of the lower interest rates corresponds to a sharp increase in the growth rate of real house prices.  Beginning in 2001, the five-year growth rate of real house prices rose from 13 percent (the red horizontal line) to a maximum of over thirty percent, a rate more than double its previous maximum. 

Timing does not eliminate the Fed’s culpability. 

Interest Rates and House Prices

“Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.  This conclusion has been reached using both econometric models and purely statistical analyses that make no use of economic theory.” 

Notice, the Chairman slipped quietly from economic theory guiding the choice of Taylor Rule in the previous section to statistical analysis in this section.  This switch seems odd given the robust theoretical relationship between monetary policy and house prices.  If monetary policy controls the real interest rate, then lower interest rates translate directly into higher long-term house prices. 

To test this thought, I plug the path of interest rates into a completely standard model of house prices and consumption.  (If you want details, post a comment or email me.)  Using data on the housing stock, I find the change in interest rates accounts for most of the change in house prices over the period in question.  One cannot dismiss the possibility that looser monetary policy led to the increase in house prices.  And, it’s this point in its many guises that lead many critics to blame Fed policy. 

However, the same standard model of housing does a very poor job of matching house prices between 1980 and 2000.  The historical relationship between house prices and real interest rates in the United States is quite weak.  Take a look at the longer picture below.  Mortgage interest rates fell from 18 percent in 1981 to less than 10 percent in 1987.  The cumulative rise in house prices was less than 10 percent.  Likewise, between 1990 and 1995, interest rates fell about 2½ percentage points; house prices were about unchanged, on balance, over this period.  I would also note here that VAR models are also unsuccessful in reproducing, out of sample, house prices in any 10 year period between 1980 and 2009. 

A recent paper (here), builds a statistical model that explains the discrepancy.  They show that the interest rate negatively covaries with the risk premium on housing.  In other words, falling interest rates are always exactly offset by some other factor.  The authors give no reasonable explanation of the negative covariance. 

Nonetheless, across countries and across time, house prices have risen when long-term rates are low.  A 2005 Fed Study found a strong, lagging relationship between interest rates and house prices.  Take a look at Chart 3.7 in the linked paper.  There, a decline of about 1 percentage point was associated with a 15 percentage point increase in real house prices, on average.

So, the evidence is mixed:  theory is clear, empirics less so.  Lower interest rates should raise house prices and the lower rates observed in the 2000’s are exactly consistent with the rise in house prices.  But, their historical relationship in the United States belies this effect.  The historical relationship is why the VARs reject policies role in the house price run-up.  I wonder what a cross-country VAR would produce. 

But the Fed believed in the link between housing and interest rates

The Fed tried to bring down long-term interest rates.  During the period of loose policy, the Fed had the specific intention of pushing down long-term interest rates by promising to keep its policy rate low for an extended period.  Even when the Fed began to raise rates in 2004, it emphasized that the increases would be measured (their word, generally taken to mean a slow increase over a long period of time).  As we saw above, this policy seems to have been at least partially successful. 

The Fed also believed in the link between the movements in long-term interest rates and the increase in house prices.  Here is the Fed speaking in the voice of then Gov. Bernanke:

The decision to purchase a home is probably the most interest-sensitive decision made by households … I expect residential investment to continue strong this year. Mortgage rates have risen in the past month but remain low relative to historical experience, while new household formation, improved job prospects, and income growth should ensure a continued healthy demand for housing.  Bernanke April 22, 2004  

These two ideas lead me to believe that the Fed thought it was influencing the housing market. 

My Last Word

I don’t know if loose monetary policy caused the run-up in house prices.  My instincts, however, continue to tell me that monetary policy is not the culprit.  (I tend not to ascribe so much power to monetary policy.) 

Nonetheless, the circumstantial case is somewhat persuasive. 

The Fed was loose; interest rates fell; house prices rose. 

Simply dismissing these facts is not productive.  I would expect a more robust

Are Moratoria Ever Needed? Can the market do its own workouts?

The following post is a response to BCG81 who commented on this post:

The distinction between temporary and permanent income shocks ought to lead a workout guy to give you restructurings where that is the higher-NPV alternative [relative to foreclosure]. 

First, to be clear, I do not believe foreclosure moratoria are the best policy instrument at the moment.  I continue to believe my foreclosure plan (see it here) is the best permanently workable plan.  Note, in particular, that it has the benefit of not needing a temporary versus permanent distinction and induces no forward-looking market distortions.

But, to your point and thinking solely about moratoria, I agree.  Banks are good (not perfect but good) at taking actions that are best for them.  If/when banks find it in their interest to do wide scale workouts, they will do so.  But with foreclosures there is likely an important macroeconomic externality.  A foreclosure depresses local property values (see my post here), increasing the probability of further foreclosures, and potentially devastating neighborhoods.  .  The bank, correctly, does not take this fully into account.  Accordingly, it may be socially optimal to prevent foreclosures even when workouts yield lower bank profits. 

In addition, in depressed neighborhoods, banks should rush to foreclose.  The sooner they take possession and dump the property the higher their profits are likely to be.  It’s a poor equilibrium but each bank should follow this strategy.  And, the most efficient foreclosure bank will indeed likely perform the best.  This rush to foreclosure may speed adjustment where it is needed but may also put neighborhoods, which would have been only temporarily impaired, over the brink. 

I am not saying banks can’t do the workouts.  I am only saying the policy and banking motivations are not aligned. 

One problem is the lending that drove house prices and pretty much the rest of the economy through 2007, income just didn't matter.  Nobody paid any attention to whether the borrower had enough income to repay. So a big—maybe the biggest—part of the problem is probably automatically equivalent to a permanent shock.

In early 2007, we could have argued over your motivating fact.  Poor lending standards might have been the culprit.  I think, though, that with the acute perception of hindsight the evidence now leans in favor of an income shock not poor lending standards.  Be that as it may, your point stands.  Many households borrowed more than they could afford with their realized income.  And these households are likely the biggest part of the current problem.  Blanket moratoria are likely preventing adjustment in these dimensions. 

Also, don’t moratoria in response to temporary shocks also keep the market from adjusting "in a good way"? Couldn't this build inventory, potentially increasing supply relative to demand and causing prices to fall during the time it takes to resolve the temporary shock. And depending on how you restructure the loan during this period (e.g., is interest paid? capitalized?), it may offer lenders a lower recovery than foreclosure, thus impeding the deleveraging process.

Too true.  Moratoria, even temporary ones, distort markets.  Without short-term price adjustment, supply may increase, pushing house prices down once the moratoria is lifted.  But the moratoria, assuming the shock was correctly identified, do not impede the deleveraging process.  Households who face a temporary shock do not need to deleverage; they may want to delever but by definition they can afford their current debt level. 

The model seems to be the LDC debt crisis of the 1980s. Personally I think this overstates the importance of the banking system (beyond its ability to clear payments and provide working capital) in an environment like this and over prioritizes it in recovery policy/strategy.

Touché.  The LDC crisis resolution is exactly the moratoria model.  Those economies suffered temporary shocks and moratoria allowed them to repay most of their debt.  And, in the process, turned them into permanently indebted, serial defaulters. 

Defeated, I can only repeat my first point.  I do not believe foreclosure moratoria are the best policy tool available.  I like my plan—still feel free to have at it if you are so inclined. 

Foreclosures and the Housing Market

This note is in response to a comment by BCG81.

To your point here, I read recently (Mark Hanson's blog) that one of the principal unintended consequences of the state foreclosure moratoria, loan modifications and other government "keep people in their homes initiatives" has been to deprive the housing market of foreclosure sales, and thus of its main driver.

First, thanks for pointing out Mark Hanson’s blog.  I read a few of the posts and the work there is quite good.  I recommend the site. 

It’s true that foreclosure moratoria reduce the volume of houses on the market.  But is this a good or a bad thing? 

Let’s focus on the income side of the household’s balance sheet.  Consider a household that experiences a combination of temporary and permanent shocks to income.  Without getting overly technical, think of a temporary shock as an unemployment spell followed by reentry into the same industry at the same wage and a permanent shock as an unemployment spell followed by reentry into a low wage industry. 

Foreclosure policy must consider the type of shock hitting the household.  If the shocks are permanent, the household entering foreclosure likely needs to move to more affordable housing.  In this case, a foreclosure moratorium does nothing but slow the adjustment of the housing market.  It also slows adjustment of the labor market as the household will be hesitant to give up their free housing to conduct a job search outside of their local area.  With permanent shocks, foreclosure moratoria should not be used. 

What about temporary shocks?  It’s true; during the period of unemployment the household cannot afford their house.  But the situation is temporary.  In a year or possibly two years, the household will be able to afford their current house.  In a frictionless market, the household should move anyway.  During their period of unemployment, the household should consume less housing; just as they are likely consuming less of other goods.  But the housing market is far from frictionless.  A foreclosure moratorium, in this case, prevents the market from adjusting, in a good way. 

So, foreclosure moratoria are good or bad depending on the nature of the shocks facing households.  I think the economic situation calls for nuanced policy.  In some areas, places where the downturn is clearly temporary, a foreclosure moratorium is likely helpful.  In other places, Detroit, a moratorium is likely to prevent needed long-term adjustment. 

On a side note, none of the moratoria that have been used to date are long enough to be helpful.  Three to six months is simply not long enough to allow a reasonable adjustment.  I think moratoria should be in place for at least a year to have any hope of being effective.  Further, I think moratoria should be considered on a case-by-case basis rather than wholesale for entire regions.  Households should justify their need.  We cannot measure whether or not they have a permanent or temporary shock, lacking a crystal ball, but we can tell if they have an income shock.  A household that can’t afford their mortgage with their existing mortgage needs to move on.

Monetary Policy and House Prices: Evidence from the States

Did the Fed cause the housing bubble?  I don’t know the answer but the issue has received renewed interest since Governor Bernanke gave a talk at the AEA meetings categorically denying any culpability on the part of the Fed.  I too question the ability of monetary policy to create a bubble in housing (or stocks) without, over a long period of time, also creating a high level of inflation.  However, if we examine evidence across U.S. states instead of across countries, where the data may or may not be comparable, there is a statistically significant relationship between the easiness of monetary policy and the rate of house price appreciation.

Bernanke’s Comparison Across Countries

In addition to a weak model-based defense, Bernanke showed the following picture.  The scatter plot shows the relationship between the average residual in the Taylor rule between 2001Q4 and 2006Q4 against the cumulative change in real house prices.  The relationship shows a weak but positive relationship between the change in house prices and the looseness of monetary policy.  The lack of statistical significance I cannot debate; however, Bernanke also referred to a lack of economic meaning, which seems an absurd statement given the Fed’s long history of speaking on the relationship between house prices and monetary policy.  Indeed, in the early 2000s, the Fed’s favorite transmission mechanism for monetary policy was through the housing market. 

Although the lack of relationship may be real, cross-country comparisons of this nature are plagued by data and comparability problems.  The measurement of house prices (as well as the measurement of the deflator) differs tremendously across countries.  Consider the data for the United States.  If the slide had used the Case-Shiller index instead of the FHFA index, the data point for the United States would be much higher.  As well, if the house price data had been deflated by the PCE deflator instead of CPI the data point would move. 

Comparison Across States

To eliminate a host of comparability problems, I replicated Bernanke’s picture using U.S. states in lieu of countries.  The BEA produces comparable annual estimates of state GDP and the FHFA produces comparable house price indices for every state.  Using these two sources, I calculate Taylor-rule residuals and average house price growth across the states and plot the results below.  This exercise is very much akin to Bernanke’s picture considering euro area countries alone (an exercise which yields a statistically significant relationship). 

States with the “loosest” monetary policy are exactly those with the highest house price appreciation.  Unlike the picture across countries, here the relationship is statistically significant.  Indeed, those States that are “looser” than the U.S. average (-2.5) experienced more than 30 percent more house price appreciation on average than those states “tighter” than the U.S. average. 

By the way, the intercept of the line, 23.2, is only a touch below the average U.S. house price growth over the last 30 years.  In other words, as the simple regression above predicts, when monetary policy is neither too loose nor too tight, house prices should grow about 4 percent per year (or 23.2 percent over five years).  If we believe this result, then the Fed’s loose policy stance over this period added 32 percentage points to the growth rate of house prices between 2001 and 2006.  Since total growth was 48 percent, the Fed’s policy accounted for two-thirds of the total increase in house prices, according to this calculation. 

House Prices vs. GDP and Inflation

In his speech, Bernanke pointed out that the relationship might be spurious:  those economies with the highest growth might be precisely those with the loosest policy.  I am not sure the logic follows for certain; the statement seems to imply some additional unstated constraints on monetary policy. 

In any case, the picture below shows the scatter plot for the states where average annual GDP growth is substituted for the Taylor residuals.  Note that the R² is actually zero.  The slope is not only statistically insignificant, the point estimate is zero. 

Likewise, no substantial relationship can be found plotting state average annual inflation.  Indeed, the statistically insignificant slope goes in the wrong direction:  states with the highest inflation had, on average, the lowest nominal appreciation of house prices. 

Conclusion

These pictures are far from proof that monetary policy caused the house price boom.  But, they can also not be easily dismissed.  Although I personally do not believe monetary policy is capable of producing these types of long-term effects, the case is far from closed. 

I find the statistical fit across states disturbing.  The simple Taylor model yields not only a believable distribution, out of sample, it nails the long run average growth of house prices.  I know most economists reject this exercise within the United States but I would like to hear Bernanke explain why it is okay for the euro area but not for the U.S. 

In my next post, I will explore the theoretical link between house prices and monetary policy.  Conditional on the Fed having some control over the long-term rate, the link is direct and large.  The post will show that Bernanke's interest rate chart in his speech was likely misleading.