Housing Crisis Implications on Monetary Policy

MBA (4/22/2008 ) Palaparty, Vijay
Financial innovation has altered the role of the housing sector in the business cycle globally, and monetary policy should give specific attention to house prices, panelists said yesterday at a Brookings Institution seminar.

“Monetary policymakers may need to respond more aggressively to housing demand shocks in more developed mortgage markets—that is, with higher LTV ratios and thus, presumably higher stocks of mortgage debt,” said Roberto Cardarelli, senior economist at the International Monetary Fund . “They may also need to respond more aggressively to financial shocks that affect the amount of credit available for any given level of house prices. Hence, the model would predict a more aggressive reduction of interest rates in the United States compared with the euro area in the face of recent turmoil in the credit markets—and this is in line with what has occurred so far.”
Cardarelli, presenting research from the World Economic Outlook released this month, said countries with more developed mortgage markets could also benefit from a monetary policy approach that responds to house price developments in addition to consumer price inflation and output developments.

“In a risk management framework, such an approach would need to accommodate the uncertainty about what factors drive house price dynamics—in particular, whether house prices reflect changes in fundamentals or speculative forces—and their impact on the economy," Cardarelli said.

While IMF views house prices as an appropriate indicator to calculate overall risk to economic activity and prices, Douglas Elmendorf, senior fellow at The Brookings Institution, opposed the call for monetary policy to adapt to effects of financial innovation. He called for more attention on regulatory policy, which he suggested the IMF report mentioned but did not highlight.

“The federal funds rate reflects expected inflation and output,” Elmendorf said. “The way output and inflation gaps are forecasted need to respond to financial innovation, with a consciousness of risk. House prices became a central part of the economic forecasts, reflecting the ability of borrowers to use cash-out financing for spending—using housing-backed debt."

Elmendorf called for better economic forecasting, acknowledging the difficulty in detecting bubbles—what he defined as irrational exuberance. “Counter-cyclical policy is a blunt too; to address asset price problems,” he said. “People need to be explicit about how to quantify that and its effect on the rest of the economy. Policy should be forward-looking because it always functions with a lag. If one incorporates inflation and output changes in the economy, adding house prices as a second consideration would be significant.”

Elmendorf said the Fed, through regulation, should address asset price imbalances. “It would restrain and leverage risk-taking—the extent to which asset bubbles are created and the extent to which they fall,” he said. “That’s a difficult and long agenda. The right policy response to financial innovation and the rest of the economy is more complex than it used to be.”

Simon Johnson, economic counselor and director of the Research Department at IMF, said monetary policy should consider house prices more symmetrically. “The link between housing and monetary policy has become stronger," he said.

The IMF research said the increased use of homes as collateral amplified the spillover of the housing sector to the rest economy—worldwide—strengthening the financial accelerator effect. “This poses new challenges for monetary policy, especially in economies with more developed mortgage markets. There is a need to aggressively react to house prices and house prices inflation," Cardarelli said.

Elmendorf outlined different forces working to different degrees, addressing how financial innovation in housing amplifies disturbances in some areas while dampening in others. “First, the effect of change in interest rates on housing construction—the supply of mortgage credit is less sensitive and that change along produces volatility in the economy,” he said. “The effect of financial innovation on housing construction and house prices makes it easy to borrow using collateral. The effect of increased prices will encourage households to borrow more.”

As households borrow more, house prices as well as expectation could rise, Elmendorf said, in a " self-fulfilling cycle” where high house prices lead to high construction. “Over the past several years, homeowners became excessively confident and made the bubble larger than it should have been,” he said.

Elmendorf added that the movement of house prices affects consumer spending. “Traditionally, house prices affect consumer spending through a wealth affect,” he said. “The ability to borrow more easily against housing has accentuated the movement on spending. Households can borrow more—they borrow more and buy bigger houses and a shock in house prices reverberates through the economy. It’s almost as if a person is using a house as an ATM. A collapse in house prices stops that and further crimps the ability to spend.”

Cardarelli said his primary concern is with correctly accounting for home prices. “In order to correctly account for house prices, developments in mortgage markets needs to be accounted for. Do we have the model and ability to take house prices on board?” Risk management approaches take into account events down the road. If you combine uncertainty and the fact that central banks don’t have models and models of economy that take housing into account—maybe they will be ready 10 years from now—and account for the link between housing and business cycle, there may be cases to take house prices into consideration.”