A Bubble in the Housing Market?

At the June 29-30, 2005, meeting, the FOMC held a special discussion on the possibility of a housing price bubble and its implications for monetary policy. The general tone of the meeting was to first consider the evidence for there be­ing a bubble.

The opening presentation, by staff economist Josh Gallin, introduced the ba­sic data and reported on a regression analysis using that data:

The first point to note is that the measured price-rent ratio is currently higher than at any other time for which we have data.... Most notably, in the first quarter of 2002, the last observation for which we have a reading for the subsequent three-year change in house prices, the price-rent ratio stood at 22. Although the regression suggests that real prices should have been about flat since then, real prices actually increased more than 20 percent, and the price-rent ratio rose to about 27—literally off the chart. The regression analysis also suggests that prices are about 20 percent too high given rents and carrying costs. (FOMC, 2005b: 5-6)

The meeting continued with a series of reports that considered the data from a variety of perspectives. It is useful to present some of this discussion, as it shows how a possible house price bust was analyzed from a macroeconomic point of view. Glenn Rudebusch, of the San Francisco Federal Reserve, laid out the basic logic of how the Federal Reserve should think about what to do if there was a housing bubble by considering its potential impact on the economy from a macroeconomic perspective:

I will review some general issues related to monetary policy and asset prices.

The Setondlype of resp thise, lhe “B Libbk Policy” fo Hows lhe -Slandard Policy as a base case, but, in certain circumstances, it also takes steps to contain or reduce the asset price bubble. Proponents of a Bubble Policy argue that movements in the bubble component can have serious adverse consequences for macroeconomic performance that monetary policy can­not readily offset after the fact, so it is preferable to try to eliminate this source of macroeconomic fluctuations directly. Furthermore, because bub­bles often seem to display a self-reinforcing behavior, a little preemption and prevention early on can avoid later excesses. (FOMC, 2005b: 14-15)

San Francisco Reserve Bank senior vice president John Williams was one of the few participants who unequivocally thought there was a house price bubble. He accepted Mr. Gallin's estimate that house prices were 20 percent above their true value. He then used the FRB / US model to estimate the effect of several scenarios about what would happen to the economy if there was a decrease in housing prices of 20 percent:

As Josh Gallin indicated, it would take up to a 20 percent decline in house prices to bring the price-to-rent ratio back in line with fundamentals.

But he went on to suggest that while this was substantial, its impact was not as grave as that of the stock market crash of 2000-2001:

It may be useful to put these figures into context by comparing them to those associated with the stock market overvaluation reached in ear­ly 2000. Stock prices at that time were arguably some 50 to 70 percent overvalued. Correction of prices to fundamentals at that time would have implied a reduction in household wealth of $6.7 trillion, equal to about 70 percent of contemporaneous GDP. In the event, stock market wealth fell by $4.6 trillion between March 2000 and March 2001, and at its lowest point was down $8.5 trillion. There is considerable uncertainty regard­ing the magnitude of the effects of changes in stock market and housing wealth on household spending; nonetheless, it seems clear the magnitude of the current potential problem is much smaller than, and perhaps only half as large as, that of the stock market bubble. (FOMC, 2005b: 18)

Other committee members sought ways to explain the house price run-up in terms of economic fundamentals. Alan Greenspan focused on the price of land, asking, “Is it credible that we can have a consistently more rapid rise in prices of existing homes unless the value of land is rising faster for those homes?” (FOMC, 2005b: 70). Other members adopted similar frames. Governor Mark Olson's as­sessment focused on land values and “the incidence of teardowns,” while Dallas Reserve Bank president Richard Fisher stressed “land use restrictions” (FOMC, 2005b: 39-41).⁷ Thus, committee members fit housing prices into a narrative of “hard,” observable factors affecting supply and demand.

Not surprisingly, then, many participants questioned the very notion of a bub­ble. New York Reserve Bank vice president Dick Peach captured this sentiment:

Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy. Indeed, housing market ac­tivity has been quite robust for some time now......... But such activity could

be the result of solid fundamentals underlying the housing market. After all, both nominal and real long-term interest rates have declined substantially over the last decade. Productivity growth has been surprisingly strong since the mid-1990s, producing rapid real income growth primarily for those in the upper half of the income distribution. And the large baby-boom gener­ation has entered its peak earning years and appears to have strong prefer­ences for large homes loaded with amenities. (FOMC, 2005b: 11)

Peach further suggested, “Home prices actually look somewhat low relative to median family income” (FOMC, 2005b: 13).

Similarly, St. Louis Reserve Bank president William Poole only half-jokingly argued, “Just for the hell of it, I'd like to offer the hypothesis that property values are too low rather than too high” (FOMC, 2005b: 57). House prices, in Poole's understanding, were a function of low real interest rates, which in turn reflect­ed transformed fundamentals in the global economy. Poole concluded, “I offer those observations because, if we are in a world that is going to have much lower real rates of interest for some time to come, one would expect to see the price-to- rent ratio go up. Maybe this line in the chart has another 40 percent to go to get to equilibrium!” (FOMC, 2005b: 58).

Jeffrey Lacker, president of the Richmond Federal Reserve Bank, offered his own explanation for the rapid rise in house prices in some urban areas:

I've been struck by the fact that a collection of large metropolitan areas increasingly dominates the national housing figures and that house-price appreciation seems different across various urban regions. It suggests to me that housing values may be affected significantly by—I don't know exactly how to phrase this—sort of the relative microeconomic value of agglomeration.

Mr. Lacker concluded by noting,

It seems to me as if there are a lot of plausible stories one can tell about fundamentals that would explain or rationalize housing prices. Obviously, low interest rates have to top the list. Strong income growth among home owning populations would be on the list, as would land use restrictions, which were mentioned earlier, and the recent surge in spending on home improvement So, from that point of view, it's hard for me to see how

it would be reasonable to place a great deal of certainty on the notion that housing is significantly overvalued, or that there's a bubble, or that it's go­ing to collapse really soon. (FOMC, 2005b: 62-63)

Several participants did note the possibility that demand for securitized mort­gage debt and the associated proliferation of novel mortgage products might have been driving a price bubble. While the FOMC was aware that this shift had occurred, they mostly argued that the housing market was being driven by consumers who wanted to buy houses. They remained skeptical of the idea. For instance, Janet Yellen, president of the San Francisco Reserve Bank, questioned the notion that “creative financing” was producing a bubble:

One view that I think is very prevalent is that the use of credit in the form of piggyback loans, interest-only mortgages, option ARMs [adjust­able-rate mortgages], and so forth, involves financial innovations that are feeding a kind of unsustainable bubble.

Note that in her argument, the high prices for housing would eventually shut off the demand for housing. Implicit in this perspective is the notion that finance was not causing events in the real economy but was only responding to the un­derlying supply of housing and the demand for it.

In sum, given the real supply-and-demand factors thought to be driving the housing market, most of the FOMC judged that evidence of a bubble was at best inconclusive and perhaps even nonexistent. Even if one granted that house prices might be overvalued, the worst-case scenario provided by macroeconomic mod­eling did not appear to be very dramatic. As Chicago Reserve Bank president Michael Moskow concluded, “I come away somewhat less concerned about the size and consequences of a housing bubble than I was before” (FOMC, 2005b: 48).

Housing Price Correction

After this discussion of bubbles, housing markets stayed on the FOMC agenda. By early 2006, committee members were anticipating a “correction” in housing prices and an associated “cooling” in housing activity, but they remained broadly optimistic about its consequences.⁸ The risks posed by housing to the real econ­omy involved two principal channels, according to the narrative constructed by the FOMC. First were the direct effects on the residential construction and real estate industries. Second were the indirect effects on consumer spending through declining home equity and, even less directly, declining consumer confidence.

Neither of these channels constituted a major source of concern. First, from the FOMC's macroeconomic perspective, the contribution of the housing sec­tor to GDP was not that large. As Federal Reserve chair Ben Bernanke noted in March 2006, “residential investment is, of course, only about 6 percent of GDP” (FOMC, 2006a: 97). Even when including the potential damage to as­sociated manufacturing industries such as appliances and furniture, Bernanke reminded the committee in December 2006 that “this is about 15 percent of the economy compared with 85 percent of the economy” (FOMC, 2006c: 81). Sec­ond, committee members believed that consumption would be cushioned by strong employment, rising real wages, and supportive lending conditions. Gary Stern, president of the Minneapolis Reserve Bank, captured the general consen­sus: “As long as employment continues to go up, incomes continue to go up, and mortgage rates remain relatively moderate, then I would expect that we would avoid severe difficulties in housing except for a few markets that are particularly inflated at this point” (FOMC, 2006a: 55-56).

Over the course of 2006, as incoming housing data grew increasingly weak, members began talking of a “bimodal economy”—softening housing, manufac­turing, and autos versus a robust service sector. Yet the committee maintained that as long as the housing correction failed to produce “spillovers” into other sectors—which, they agreed, was unlikely—it would actually be good for the long-run stability of the economy. As Federal Reserve governor Frederic Mish­kin argued in September 2006, “We're actually moving resources from a sector that had too much going into it, into sectors that need to have more resources at the present time. So, in that sense, I'm actually quite positive” (FOMC, 2006b: 85). Mishkin stuck to this rebalancing narrative as late as June 2007, after the deterioration of the subprime market was underway:

My view of what has been happening in the economy is that we have been basically going through a rebalancing. We had a sector that was clearly bubble-like with excessive spending, and now we are getting the retrench­ment, which is taking a bit longer than we expected. But the good news is that we are going through a rebalancing in which we are just moving resources to other sectors and that is actually going much along the lines that we want to see. (FOMC, 2007b: 87)

In fact, while the FOMC saw housing as the major threat to growth during this period, the committee's predominant concern was not growth at all but inflation. Until September 2007, official FOMC statements continued to main- tain—and most members agreed—that inflation remained the principal risk to the dual mandate.

This analysis reflected the macroeconomic framework that the FOMC em­ployed to make sense of housing. Committee members visualized the economy

in terms of sectors, each making an independent contribution to GDP. They be­trayed a deep-seated bias toward primary markets (such as home sales and home loans) and the nonfinancial sectors of the real economy (such as construction and manufacturing) rather than secondary markets embedded in the financial economy (such as MBSs, CDOs, CDSs, and the financial institutions that held them on their books).

The structure of the Federal Reserve System reinforces this sectoral thinking and bias toward nonfinancial markets. A large part of every FOMC meeting is devoted to the oral presentations of Reserve Bank presidents regarding business conditions in their respective districts. Much of this discussion involves pres­idents' reports from CEOs and other business contacts in their districts. But, while there are twelve districts in the Federal Reserve System, the financial in­dustry is overwhelmingly concentrated in a single physical location, lower and midtown Manhattan. Consequently, when presidents talked to their contacts about the housing market, they overwhelmingly talked to homebuilders, real­tors, construction companies, and regional mortgage originators, actors attuned precisely to local real estate conditions rather than the financial economy. This made it difficult for members of the FOMC to see where the dangers from hous­ing really resided—at the heart of the financial industry itself.