Wednesday, January 6, 2010

The Chairman Speaks

The Lehmann Letter ©

On January 3 Federal Reserve Chairman Ben Bernanke spoke before the annual meeting of the American Economic Association:

Mr. Bernanke concluded his remarks by saying:

“My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak. Because monetary policy works with a lag, policymakers' response to changes in inflation and other economic variables should depend on whether those changes are expected to be temporary or longer-lasting. When that point is taken into account, policy during that period--though certainly accommodative--does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives. House prices began to rise in the late 1990s, and although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policies and the pace of house price increases.

“What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders' risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates. Moreover, regulators, supervisors, and the private sector could have more effectively addressed building risk concentrations and inadequate risk-management practices without necessarily having had to make a judgment about the sustainability of house price increases. “

In other words, lax mortgage-market regulation rather than low interest rates generated the 2002 – 2006 housing bubble.

Take a look at the following chart.

New Home Sales

(Click on chart to enlarge.)

Recessions shaded

Home sales slumped during earlier recessions but not in the 2001 recession. Cutting interest rates was an appropriate remedy for the previous dips because drooping home sales had been an important part of those downturns. When interest rates fell, housing snapped back to normal.

But housing did not slump during the 2001 dot-com bust. It remained at very high levels. When the Fed cut rates, housing surged into the stratosphere. What had been a high plateau became a peak.

That doesn’t mean that lax lending did not play an important role in the 2002 - 2006 housing bubble. But it does reinforce the question: Was the 2001 - 2002 interest-rate reduction warranted?

Which raises a related question, “Could the Fed have refused to cut rates in the midst of the dot-com crash?” The political realities say, “No.” If that’s the case, the real-estate bubble was unavoidable under current monetary policy procedures and expectations.

Only a top-to-bottom review of those procedures and expectations, involving Congress and the president as well as the Fed, could create the appropriate climate for a more flexible approach to monetary policy. That might help avoid another debacle like the 2002 – 2006 real-estate bubble.

(The chart was taken from [Click on Seminars and then Charts.] Go there for additional charts on the economy and a list of economic indicators.)

© 2010 Michael B. Lehmann

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