In a paper presented at the Fed’s Jackson Hole conference, Federal Reserve governor Frederic Mishkin urged central bankers to respond quickly and aggressively to large falls in housing prices, arguing that it was less effective to wait to see the impact of falling housing prices on the economy.
Mishkin disputed the notion that consumer use of home equity to fuel spending plays much of a role in consumer spending (a view held by Greenspan); he looks instead to a more generalized wealth effect. However, in what sounds to me to be a bit of hairsplitting, he said that home price appreciation gave consumers more access to credit via having more collateral, making spending more responsive to housing price changes.
Now as a mere mortal, as opposed to a Serious Economist, I continue to be bothered by the lack of discussion of what happened in economies that had serious housing price falls (25% or more). My quick look showed they had nasty but not long lived recessions. Yes, recessions are unpleasant and hurt innocent bystanders, but we have considerable evidence of speculative activity that fed into this housing bubble. Shoring up the housing market enables, nay encourages, continued bad behavior (it’s called moral hazard). And some readers point out that high cost housing (prices have been and still are out of line with rentals and average incomes) is a tax on consumers as well.
Mishkin addressed the moral hazard problem by claiming that policy makers could address that issue by stressing that they weren’t focusing on the price of a particular sort of asset but on their price stability and employment goals. Given the focus of Mishkin’s paper, and the intense lobbying of the Fed by the housing industry and concerned Congressmen, I don’t see how it is possible to achieve that finesse. And independent of any attempt at optical illusion, the fact will remain that reckless lenders and consumers will have been shored up.
In addition, James Hamilton (enough of a Serious Economist to get to present a paper as Jackson Hole) comments approvingly on an observation by UCLA’s Ed Leamer (note he was lukewarm about other aspects of Leamer’s presentation):
I found another of Leamer’s main themes to be an intriguing suggestion. He claims we should think of monetary policy as doing very little about the long-run growth rate (which he thinks will be within 3% of a 3% annual growth line regardless of policy), and that stimulating the housing market therefore just changes the timing. Specifically, Leamer believes we bought ourselves a boom in 2004-2006 at the expense of a recession in 2007-2008.
That view suggests that monetary stimulus is no free lunch.
From the Financial Times:
Central bankers should ease monetary policy quickly and aggressively in response to a big fall in house prices, Federal Reserve governor Frederic Mishkin said on Saturday.
Presenting a paper on the final day of the Fed’s Jackson Hole symposium, Mr Mishkin said policymakers should not wait until output falls, but should “react immediately to the house price decline when they see it.”
He said the optimal policy response was both quicker and more aggressive than that suggested by a standard policy rule, in which policymakers respond only to deviations in output and inflation.
He said simulations show that this approach “can be very successful at counteracting the real effects” of even a large house price slump, because of the long lags from changes in housing wealth to changes in consumer spending.
That time lag gives the central bank “plenty of time to respond” to the house price decline.
In a base case simulation of a 20 per cent fall in US house prices, the more rapid and aggressive policy response halved the decline in gross domestic product to just 0.25 per cent relative to baseline after three years.
Mr Mishkin said he was not suggesting that getting the right response to a house price slump is easy, but that “monetary authorities have the tools to limit the negative effects on the economy from a house price decline.”
The Fed governor said housing and mortgage markets have not been “close to the epicenter of previous cases of financial instability.”
But he added “I would note that the current situation in the US could prove to be different.”
He said the recent experience with subprime loans fitted a boom-bust pattern of financial innovation.
Rapid financial change, triggered by innovation and deregulation, leads to a lending boom. This process, Mr Mishkin said, deepens the financial system and is “vital” for the economy in the long run.
But he said a lending boom can “outstrip the available information resources in the financial system, raising the odds of costly, unstable conditions in financial markets in the short run.”
The clear inference was that Mr Mishkin believes this to be the case in the subprime sector.
Mr Mishkin said researchers differ on the extent to which increases in housing wealth boost consumption.
But he said it seemed reasonable to work on the basis that it was similar to the wealth effect from financial assets – about 3.75 cents of extra spending per dollar of housing gains.
Mr Mishkin poured cold water on Alan Greenspan’s theory that mortgage equity withdrawal plays an independent role in driving spending.
“We do not think that ATM withdrawals drive consumer spending, so one must doubt whether mortgage equity withdrawals do so,” he said.
However, Mr Mishkin said the most important channel through which changes in house prices effect spending could be via their effect on balance sheets and credit collateral.
Citing research by Fed chairman Ben Bernanke among others, Mr Mishkin said a rise in house prices gives homeowners more collateral, and so more to lose in the event of defaulting on a loan.
That helps overcome the information problem between lender and borrower (which arises from the fact that the borrower knows his own financial situation better than the lender) making finance available at a lower rate than would otherwise be possible.
By contrast, if house prices fall, the “financial premium” that has to be paid by households that want to borrow would go up.
Mr Mishkin said greater ease of mortgage equity withdrawal could help relax credit constraints, and thereby make consumer spending more sensitive to house prices.
The Fed governor reaffirmed the established Fed line that central banks should not set out to try to pop or even lean against asset price bubbles, beyond taking into account the effect of higher asset prices on spending. He said it was better to clean up after a bubble burst.
Mr Mishkin said that a central bank could “mitigate” the concern that easing monetary policy following the collapse of an asset bubble would make future bubbles more likely if it “publically emphasises that its monetary policy is not directed at stabilising any particular asset price but is rather focused on achieving price stability and maximum sustainable employment.”
In the increasingly likely – if not yet certain – event that the Fed decides to cut interest rates in response to the current financial market turmoil, this is likely to be the way in which it presents its decision.
Update 9/1, 9:00 PM: Reader Constantine, in comments below, noted that the Wall Street Journal’s Economics Blog had a very different take on what Mishkin said:
U.S. housing prices shouldn’t get special emphasis when it comes to monetary policy, though central banks should be ready to deal with their broader macroeconomic consequences, Federal Reserve governor Frederic Mishkin said Saturday.
Mishkin’s comments, which came in the form of a paper presented at the Kansas City Fed’s Jackson Hole conference, reflect the fine line policymakers are walking right now. After all, housing has significant potential ripple effects on employment and inflation, which are the Fed’s mandated responsibilities.
I could be wrong, but the impression I have is that the WSJ post is based on reading Mishkin’s paper, and not on having heard his presentation at the conference, while the FT appears to be quoting remarks he made.
That poses an interesting question. If this is correct, that implies there was a considerable distance between what Mishkin’s paper said and what he recommended in a talk supposedly about the same paper.
Note that Mishkin, both to a degree in the paper and apparently more clearly in his remarks, urged central bankers to dissemble when they cut rates to combat a housing price drop, and attribute their actions instead to more general price stability and employment concerns.
So was MIshkin keeping his real policy view out of the paper to further the goal of plausible deniability?