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term money markets, after regulation Q (which had several restrictions on mortgages including ceilings on rates) was repealed.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.