FED and fin crisis: Part II

Indeed, the linkages of the local mortgage market with international markets in the period, has reduced impact of the fed funds rates on home finance. As the Chairman of the Fed, Benjamin Bernanke pointed out in 2007, mortgage credit is now less dependent on conditions in short term money markets, after regulation Q (which had several restrictions on mortgages including ceilings on rates) was repealed.
Loose or tight monetary policy should affect all classes of investments roughly equally. But total investment to GDP in 2001-05 has no trend. On the other hand, residential investment displays a sharp uptrend as was already shown. The rise in only one type of long term investment is difficult to rationalize. It is clear that circumstances peculiar to the housing market was responsible for the same. The argument that this happened because all other asset classes were depressed is frequently made. However, while stocks certainly took a beating after the tech bubble had burst, this does not reflect the fact that overall investment also did not rise. Even though stocks may have been depressed, the time period is too long to justify this argument. If loose monetary policy should stimulate one class of investments, other classes should also be at least partly stimulated.
Finally, the imbalances in the market (to be discussed briefly following this argument) led to a sharp fall in the spreads of many securities. Banks seemed to somehow assess risk to be much lower than in the past. This happened independent of the loose monetary policy of Fed and offers a reason for housing ownership to rise even though long run fundamentals did not change. Thus, the relevant interest rate would have fallen irrespective of Fed monetary policy and is a better explanation for the crisis.

Real house prices rose 86% between 1996 and 2006. Was this necessarily a bubble? If so, how is the fundamental value of a house determined? It should be noted that high prices alone do not necessarily imply a bubble. The current price of house typically equals the expected stream of real rents and the discount rates (long run interest rates) for the period of the house. The period of 1996-2000 seems fairly valued based on this metric. (The prior period was a period of depressed prices versus historical averages and good GDP growth justified the rise).
However, 2001-05 clearly showed a divergent trend from fundamentals. Real home prices were 70% higher than real home rent as shown in figure 2. This clearly represents a bubble. The only way this rise is acceptable is if there is an expectation that real rent would increase a lot over time or long term rates are going to fall a lot. However, neither was the case. Average GDP growth in 2001-05 was much lower than those during 1996-2000 (2.3% versus 4.6%) while unemployment was higher (5.4% versus 4.6%). So clearly rents are not a factor. Also, as was already argued, for a long term investment like homes you cannot expect a rational agent to believe that a counter cyclical monetary policy would result in low rates for ever (on the other hand it is rational to assume that although prices are inflated, we can still make a quick buck by selling before the bubble bursts).
Is there any other reason for long term interest rates to be low? Clearly fed rates affected the long term interest rates. But long term rates are affected only if future short term rates are also expected to fall. So what is the reason for this connection?
Clearly Robert Shiller’s psychological theory (that people keep assuming rising prices once it passes a threshold) is applicable to home or stock price bubbles. But to extend the same argument to interest rates is a stretch of imagination. One reason often cited is that core inflation in 2001-04 saw a sharply negative trend. Thus there was a general feeling that the Fed was getting really good at controlling inflation and cheap goods from china, and improved productivity in consort with inflation hawks in most central banks around the world contributed their bit. Taylor (2007) argues that federal funds rate responsiveness to inflation dropped in 2003-05. Hence investors could have thought that a change in long term policy was possible and hence long term rates would remain low. Be that as it may, this explanation risks overemphasizing the Fed’s role.

Is the FED the sole culprit for the financial crisis?

Figure 1: Real Fed Funds Rate and residential investment in the US over the years



Figure 2: Relation between real rents and real home prices

The immediate motivation for this post is Greenspan's comment that the FED is not solely responsible and cant be held wholly accountable for the financial crisis. I hate to agree with Greenspan but I sort of agree with him on this.

First, let us look at the following fact: This is the first time in the last 50 years that the relationship between lower rates and higher residential investment is even seen. In figure 1, we can see that in the 2000-2006 time period, the fed funds rate and residential investment move in opposite directions. This has naturally led to the conclusion, obviously appealing, that lower rates would stimulate housing and prolonged low rates caused the bubble. However, there have been eleven recessions in this time period in the US, nine of which were linked to declining housing markets, and none of them have even remotely shown this trend. In fact, one can claim that, based on figure 1, the Fed cuts rates whenever investment falls, rather than the claim that raising rates caused a decline in home ownership (note the almost identical routes followed by the fed funds rate and investment in housing). This is obviously misleading and hence using the theory which has been universally propagated is questionable at best.

Of course, one can argue that history is not a good guide and this time was different (as it undoubtedly was), which brings us to the next question. The period from Nov 1998 to January 2001, the fed funds rate was raised from 4.75-6%. However, from Quarter 1, 2001 to Quarter 4, 2005, there was a sharp rise in ownership coincides with sharp falls in fed funds rate. If the rate hikes that followed in 2004 really caused the bubble to burst and home prices to fall (with a lag of 2 years), then how is it that the same lagged decline is not visible after the 1998-2001 rate hikes? Clearly, the contention that monetary policy is countercyclical to investment in housing seems tenuous at best.
An even more important question is this: Economic logic dictates that the lag (assuming that there is some relation between fed funds rate and investment) should be MORE IMPORTANT for rate cuts than rate hikes. This is because rate hikes would immediately be used as a reason to deny loans and postpone new construction decisions (these can be implemented immediately). On the other hand, starting a new construction or bringing in more mortgage-financed investments is more time consuming, as would be required in the event of a fall in rates. On the other hand, we have observed the reverse: the fall in rates has no lag while the rise in rates does have a lag. In short, factors other than mere interest rate cuts where playing a far bigger role in the boom.
Housing is a long term investment: typically a house is expected as an investment over a 50 yr period or more. It is considered a durable investment. Hence, a rational economic agent will focus on long term fundamentals rather than counter cyclical monetary policy as a reason to invest in a house. . The fed funds rate is an overnight rate. It would seem that an investment would be made more on psychological factors than short term interest rates.
In the period of the bubble, there was a growing divergence between real home prices and real rent as shown in figure 2. This fact seems to have been ignored by both home buyers and lenders. This is certainly not directly related to monetary policy.

Budget 2009 (?), more stimulus and state of the economy

Budget 2009 (or vote on account?) was a singular non event.....it read like the UPA govt's election manifestos and even there it was not properly articulated. The only noteworthy issue was the increase of the defence budget which I think was better spent elsewhere.....at this time of crisis social programs deserve more funding especially given the slowness in defence spending and little stimulus from it.

A few days after the budget we get a slightly better stimulus package reducing service tax and other duties. This will help in the next 6 months to limit the damage to exports and unemployment.

Finally, the 3Q Nos suggest a massive slowdown as expected in this column......I frankly dont see any pickup in the rest of the year as consumers cut back in urban areas contrary to expectations or even current wisdom.....with salary growth all but stalled and unemployment rising, consumer confidence is ebbing fast and while it may stabilize we should not expect a bounce any time soon...all in all a depressing post to match a gloomy world economy