Housing Bubble
Fed Governor - no housing bubble but sharp price falls in some areas
March 01 , 2003
At yesterdays Conference on Finance and Macroeconomics, Federal Reserve official Governor Donald L. Kohn dealt with the question of whether the stimulus to household investment, while cushioning the economic cycle in the near-term, is setting the stage for greater instability long term. He restated the Fed view that current market activity does not represent a housing bubble, although home construction and prices could drop sharply in some areas with a risk that this could become more widespread.
His speech, "The Strength in Consumer Durables and Housing: Policy Stabilization or Problem in the Making?" aimed to address concerns that "imbalances are being created in the markets for consumer durable goods and houses--unsustainably high prices or activity--that will produce macroeconomic strains when, inevitably, they correct". He accepted that such concerns may arise from the view that monetery policy allowed the stock price bubble of the nineties to occur and some analysts argue that loose monetary policy is now feeding a bubble in housing prices that will eventually burst.
Governor Kohn also outlined a scenario where high debt levels associated with the strength in household investment could have negative consequences. He accepted that this could even occur in the absence of a housing price bubble if households were overextended and lenders had not taken adequate precautions against even a measured drop in collateral values. However he proposed that debt burdens do not look especially large and flat loan-to-value ratios on mortgages leave ample cushion for moderate housing price declines. It was felt these factors indicate "that widespread credit difficulties with important macroeconomic effects are unlikely when interest rates rise". This statement echoes Chairman Greenspans views on household debt levels.
In order to examine the possible negative effects of household investment stimulus Kohn focussed on reallocation costs and excesses.
Reallocation costs, arising from shifting resources across sectors, were not seen as a problem since "residential construction puts resources to use that would otherwise lie idle". It was accepted that as interest rates rise the recent expansion of construction firms would need to unwind. Historical seasonal fluctuations and business cycles in the residential housing market were taken as evidence of the construction industrys ability to cope with these costs. Furthermore it was envisioned that resources would be easily reallocated as commercial construction picks up and residential construction declines.
In terms of excesses, Kohn reiterated the Fed Chaiman's earlier comments regarding the difficulty of determining the existence of asset bubbles until after they have burst. He argued that it was not possible until well after the event to determine whether prices or quantities have deviated from sustainable levels. Such levels, he said, had to be estimated "and those estimates are quite sensitive to the assumptions being made".
Although house prices have risen rapidly, new house prices still have not breached the peak of the late 1970s, "but the prices of existing homes have sky-rocketed". Wealth, permanent income and price determined whether the level of housing stock desired over time at particular levels of interest rates was sustainable. Furthermore "price, in turn, depends importantly on the rate of interest". He also noted that lower refinancing costs and home equity credit had made housing wealth more liquid and therefore a more attractive asset.
Using a Fed model for desired levels of stock in the US economy he concluded that, at current interest rates, the existing stocks of houses and consumer durables are appreciably below sustainable levels. A rise in interest rates would not result in an oversupply of houses, although "we need to keep in mind that these are only very rough estimates of unobservable variables".
House price gains were seen as being fundamentally driven by low interest rates. In addition they were boosted by investors seeking an alternative to equities, with upward pressure also being excerpted by scarcity of land relative to population growth and lagging productivity in construction.
Affordability was not seen as a problem. Although the ratio of house prices to per capita disposable income has increased substantially since 1998, this has been mitigated by the fall in interest rates. Even with interest rate rises houses would still be "more affordable than they were in the second half of the 1980's".
Governor Kohn concluded that the rise in housing prices was in line with expectations and ,that as the economy recovers and interest rates rise, they are likely to soften but not break "precipitously". In comparison with other bubbles, houses and cars "do not appear set to replicate the experience of fiber-optic cable". There was a warning of the "inherently tentative--if not speculative--character" of this analysis. He also pointed out that softening of prices was likely and that "No one could definitively rule out the possibility that home construction and prices could drop sharply. Undoubtedly this will occur in some local markets, and it could become widespread".
He
argued that the aggressive lowering of interest rates was needed to
cushion the effects of contraction in capital expenditure by bringing
forward other economic activity, "It makes sense to build the
houses and cars now, when the cost of doing so is relatively low, rather
than waiting. And building them now has kept more people employed and
reduced the risk of deflation".
Source: The Strength in Consumer Durables and Housing: Policy Stabilization or Problem in the Making?
