by Bill McBride on 4/06/2010 01:04:00 PM
Tuesday, April 06, 2010
Minneapolis Fed President Narayana Kocherlakota spoke today: Economic Recovery and Balance Sheet Normalization
The headline is Kocherlakota thinks the Fed should start selling a non-trivial amount of MBS each month to normalize the Fed's balance sheet.
[T]he passive approach is a slow approach that will leave the Federal Reserve holding significant amounts of MBSs for many years to come. If the Federal Reserve wants to normalize its balance sheet in the next five, 10, or even 20 years, it needs to supplement the passive approach with an active one. In plain English, it will have to sell mortgage-backed securities.He also made some interesting comments on housing:
To pick one of many possible plans, suppose we were to commit to the public to sell 15 billion to 25 billion dollars worth per month of MBSs. This path of sales, combined with prepayments, would get the Federal Reserve out of MBSs within five years after the start of selling. The plan would also return the Federal Reserve’s balance sheet to a normal size, so that excess reserves would be normalized at their 2007 levels well before the end of the five-year period. Just as important, I feel confident that this pace of sales would be sufficiently slow that it would have little or no impact on MBS prices and long-term interest rates.
Let me start my outlook with the most troubling information first. Housing starts and sales remain at near historically low levels. These data are disturbing to many observers. And that’s understandable. After many past recessions, residential investment has played a significant role in the subsequent recovery. Arguing by analogy, some are concerned that we cannot have a sustainable economic recovery unless housing starts pick up dramatically from their current low levels.CR: I think a sustainable recovery is possible, but I think it will be sluggish and choppy. I've argued it is difficult to have a robust (V-Shaped) recovery without housing.
I have to say that I’m somewhat skeptical of this thinking. Yes, the housing sector is important, but residential investment makes up just 2.8 percent of the country’s gross domestic product.CR: This is an error in analysis. Back in 2005, several analysts argued I was wrong that a housing bust would eventually take the economy into recession - they said residential investment was only 6% of the U.S. economy! They were wrong because they didn't consider all the add on effects - and the impact of financial distress. Now residential investment is only 2.5 percent of GDP, and Kocherlakota is making the inverse faulty argument. During previous recoveries, housing played a critical role in job creation and consumer spending. It isn't the size of the sector, but the contribution during the recovery that matters - and housing is usually the largest contributor to economic growth early in a recovery.
The U.S. economy is a wonderfully diverse one, and has many possible sources of growth. We can—and I believe that we will—have significant growth in output without seeing a major turnaround in the housing market.I generally agree with this last section. The problem with "flexibility" is there are two key labor mismatches (as discussed last week by Atlanta Fed President Lockhart); The first is lower geographical mobility because of the inability to sell a home. Usually people can move freely in the U.S. to pursue employment, but many people are tied to an anchor (an underwater mortgage).
Housing starts are ... strongly affected by the general health of the economy (job growth or loss) and the stock of housing relative to demand. As I see it, the problems in the housing sector right now are largely driven by this second factor. For a number of reasons, the nation has built a lot more houses than it now needs or wants. As a result, my own prediction is that housing starts are going to remain low—possibly for several years.
What does the large supply of housing mean for the general economy? It means that resources formerly dedicated to building and outfitting homes are gradually shifting to other uses. This points out another remarkable feature of the U.S. economy: its flexibility.
The second is a skills mismatch. This is because so many people went into the construction industry because it was the highest paying job. These workers may be highly skilled in their trade, but their skills are probably not transferable to the new jobs being created. It will take some time for these people to learn a new trade.
Both of these mismatches lower the "flexibility" of the economy.