Academic journal article Federal Reserve Bank of St. Louis Review

House Prices and the Stance of Monetary Policy

Academic journal article Federal Reserve Bank of St. Louis Review

House Prices and the Stance of Monetary Policy

Article excerpt

This paper estimates a Bayesian vector autoregression for the U.S. economy that includes a housing sector and addresses the following questions: Can developments in the housing sector be explained on the basis of developments in real and nominal gross domestic product and interest rates? What are the effects of housing demand shocks on the economy? How does monetary policy affect the housing market? What are the implications of house price developments for the stance of monetary policy? Regarding the latter question, we implement a Cespedes et al. (2006) version of a monetary conditions index. (JEL E3 E4)

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The current financial turmoil, triggered by increasing defaults in the subprime mortgage market in the United States, has reignited the debate about the effect of the housing market on the economy at large and about how monetary policy should respond to booming house prices. (1) Reviewing the role of housing investment in post-WWII business cycles in the United States, Learner (2007, p. 53) concludes that "problems in housing investment have contributed 26% of the weakness in the economy in the year before the eight recessions" and suggests that, in the most recent boom and bust period, highly stimulative monetary policy by the Fed first contributed to a booming housing market and subsequently led to an abrupt contraction as the yield curve inverted. Similarly, using counterfactual simulations, Taylor (2007) shows that the period of exceptionally low short-term interest rates in 2003 and 2004 (compared with a Taylor rule) may have substantially contributed to the boom in housing starts and may have led to an upward spiral of higher house prices, falling delinquency and foreclosure rates, more favorable credit ratings and financing conditions, and higher demand for housing. As the short-term interest rates returned to normal levels, housing demand fell rapidly, bringing down both construction and house price inflation. In contrast, Mishkin (2007) illustrates the limited ability of standard models to explain the most recent housing developments and emphasizes the uncertainty associated with housing-related monetary transmission channels. He also warns against leaning against rapidly increasing house prices over and above their effects on the outlook for economic activity and inflation and suggests instead a preemptive easing of policy when a house price bubble bursts, to avoid a large loss in economic activity. Even more recently, Kohn (2007, p. 3) says

   I suspect that, when studies are done with
   cooler reflection, the causes of the swing in
   house prices will be seen as less a consequence
   of monetary policy and more a result of the
   emotions of excessive optimism followed by
   fear experienced every so often in the marketplace
   through the ages ... Low policy interest
   rates early in this decade helped feed the initial
   rise in house prices. However, the worst
   excesses in the market probably occurred
   when short-term interest rates were already
   well on their way to more normal levels, but
   longer-term rates were held down by a variety
   of forces.

In this paper, we review the role of the housing market and monetary policy in U.S. business cycles since the second half of the 1980s using an identified Bayesian vector autoregressive (BVAR) model. We focus on the past two decades for a number of reasons. First, following the "Great Inflation" of the 1970s, inflation measured by the gross domestic product (GDP) deflator has been relatively stable between 0 and 4 percent since the mid-1980s. As discussed by Clarida, Gall, and Gertler (1999) and many others, this is likely partly the result of a more systematic monetary policy approach geared at maintaining price stability. Second, there is significant evidence that the volatility of real GDP growth has fallen since 1984 (e.g., McConnell and Perez-Quiros, 2000). An important component of this fall in volatility has been a fall in the volatility of housing investment. …

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