by Calculated Risk on 4/03/2008 05:21:00 PM

The IMF has a new report out on housing: The Changing Housing Cycle and the Implications for Monetary Policy (hat tip Glenn)

Note: the IMF chart on page 13 is incorrect. This is the same error Bear Stearns made last year: see Bear Stearns and RI as Percent of GDP. It doesn't make sense to divide real quantities, since the price indexes are different. Dividing by nominal quantities gives the correct result. This Fed paper explains the error in using real ratios from chained series, and recommends the approach I used. See: A Guide to the Use of Chain Aggregated NIPA Data, Section 4.

The IMF piece analyzes the connection between housing and the business cycle (housing has typically led the business cycle both into and out of recessions). They also discuss the spillover effects of a housing boom on consumer spending, and finally the IMF argues the Central Banks should 'lean against the wind' of rapidly rising asset prices.

The main conclusion of this analysis is that changes in housing finance systems have affected the role played by the housing sector in the business cycle in two different ways. First, the increased use of homes as collateral has amplified the impact of housing sector activity on the rest of the economy by strengthening the positive effect of rising house prices on consumption via increased household borrowing—the “financial accelerator” effect. Second, monetary policy is now transmitted more through the price of homes than through residential investment.

In particular, the evidence suggests that more flexible and competitive mortgage markets have amplified the impact of monetary policy on house prices and thus, ultimately, on consumer spending and output. Furthermore, easy monetary policy seems to have contributed to the recent run-up in house prices and residential investment in the United States, although its effect was probably magnified by the loosening of lending standards and by excessive risk-taking by lenders.

We've discussed this many times: increasing asset prices (and mortgage equity withdrawal) probably increased consumer spending significantly as asset prices increased, and declining assets prices will likely now be a drag on consumer spending.

And on Central Bank policy:

[C]entral banks should be ready to respond to abnormally rapid increases in asset prices by tightening monetary policy even if these increases do not seem likely to affect inflation and output over the short term. ... asset price misalignments matter because of the risks they pose for financial stability and the threat of a severe output contraction should a bubble burst, which would also lower inflation pressure.

by Calculated Risk on 9/21/2007 11:48:00 AM

From Fed Vice Chairman Donald L. Kohn: Success and Failure of Monetary Policy since the 1950s. An excerpt on the causes of the housing bubble:

"... it is far too soon to pass judgment on what went wrong in the U.S. housing market and why. 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. To some extent, too, the amplitude of the housing cycle was heightened by the newness of the subprime market, the fragmentation of regulatory oversight responsibility for that market, and the complexity and opacity of the newer instruments for transforming and distributing risk. 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 rates were already well on their way to more normal levels, but longer-term rates were held down by a variety of forces. And similar, sometimes even sharper, trajectories of house prices have been witnessed in some economies in which the central banks said they were paying more attention to asset prices."

Many very lengthy papers will be written on the causes of the bubble. Agree or disagree, Kohn touches on a few key points: monetary policy definitely contributed to the initial surge in prices, lax oversight - Kohn says because of "fragmentation of regulatory oversight responsibility" - allowed the bubble to expand, and speculation played a key role. I'll post on what I consider the key causes this weekend.

by Calculated Risk on 9/08/2007 08:38:00 PM

"I believe disruptions in financial markets can be addressed using the tools available to the Federal Reserve without necessarily having to make a shift in the overall direction of monetary policy."
Charles I. Plosser. Philly Fed President, Sept 8, 2007

Here is Plosser's speech in Hawaii: Two Pillars of Central Banking: Monetary Policy and Financial Stability (hat tip Ministry of Truth)

On financial stability:

When financial shocks threaten financial stability, a central bank must be prepared to act promptly to forestall any subsequent large adverse effects to the economy or financial system.

However, the term “stability” in this context can be a bit misleading. While an effectively functioning financial system is usually associated with financial stability, it is not appropriate for the Fed to ensure against financial volatility per se, or against individuals or firms taking losses or failing. Policymakers must be careful to allow the marketplace to make necessary corrections in asset prices. To do otherwise would risk misallocating resources and risk-bearing, as well as raise moral hazard problems. This could ultimately increase, rather than reduce, risks to the financial system.

Thus, the Fed does not seek to remove volatility from the financial markets or to determine the price of any particular asset; our goal is to help the financial markets function in an orderly manner. I agree with Chairman Bernanke that we should not seek to protect financial market participants, either individuals or firms, from the consequences of their financial choices. The success of free markets in generating wealth and an efficient allocation of resources depends on individuals and firms having the freedom to be successful and reap the rewards of their efforts. But just as important, those same individuals must also have the freedom to fail. ...

So in the face of a sharp decline in housing and severe problems in the subprime market, the central bank must let markets reassess and re-price risk, which will ultimately lead to the establishment of new levels of prices of housing-related financial assets.

On providing liquidity:

To provide liquidity to facilitate the orderly functioning of financial markets, the Federal Reserve can make temporary adjustments to day-to-day open market operations or to discount window lending. As you know, discount window lending is collateralized lending the Fed provides to depository institutions. Providing liquidity does not necessarily require a more fundamental change in the direction of monetary policy as implemented by a change in the fed funds rate target, although that is also an option if financial sector problems spill over to significantly harm the outlook for the broader economy.

For instance, when liquidity strains appeared in the financial system in mid-August, the Fed injected a larger-than-usual amount of funds into the U.S. banking system through open market operations on several days — $24 billion on Thursday, August 9, and $38 billion on Friday, August 10. ... Operations on August 9 and 10 were larger injections of funds than is typical.

However, these operations were consistent with the objective of the Fed’s Open Market Desk in New York to provide reserves as needed to promote trading in the fed funds market at rates as close as possible to the FOMC’s fed funds rate target of 5.25 percent.

... Most of that liquidity was returned to the Fed on Monday, August 13. With markets calmer, the Fed injected just $2 billion that day — an amount consistent with many typical daily open market operations. ...

Some news stories in August reported the totals for these daily Fed operations by adding them all together, which overstated the total amount of liquidity the Fed was injecting into the financial system at any one time. Actually, many of these repo operations were overnight transactions that reversed the next business day.

All emphasis added.

UPDATE: Mark Thoma notes that the html version of the speech is followed by the usual disclaimer: "The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC." Earlier I noted the absence of this typical disclaimer in the PDF version of Plosser's speech.

It is rare for a Fed President to comment so directly on monetary policy. I'd take Plosser's comments as that it is his view that market expectations for a Fed funds rate cut in September are probably too high.