This article discusses the Federal Reserve’s pre-emptive use of monetary policy to quash real estate inflation booms, and contrasts this possible use with the current policy of merely ‘cleaning up’ recessions once they occur.
The old paradigm meets a new foe
The prevailing paradigm dominating the Federal Reserve (the Fed)’s use of monetary policy is one which eschews the ability of leaning on an economic bubble to mitigate the ill effects of that bubble imploding. The Fed’s adherence to this paradigm is well evidenced by the fact that it has scarcely ever stepped in to adjust monetary policy prior to a bubble imploding.
During the massive overextension of mortgage credit in the housing market during the first half of this decade, the Fed did little to moderate the excess mortgage money in the market. In fact, it did just the opposite. While refusing to adjust monetary policy to prevent the bubble from growing unwieldy, the Fed was more than willing to lower interest rates and inject more credit (money) into the market whenever outside pressures (notably the tragedy of September 11, 2001 and the dot-com bust) threatened market stability and growth.
Of course, there were no complaints during the easy money years. The speculators, lenders and builders profiting from the flush conditions could hardly be relied upon to call an end to the party. Wall Street wunderkinds making money hand over fist on mortgage-backed securities they were bundling and passing on weren’t going to blow the whistle either. Rating agencies added a final layer to the Ponzi system which sent the mortgage-backed bonds into AAA investment portfolios worldwide. And the federal government at the time could not have been more excited about the increase in homeownership (64-70%) the loose and excessive mortgage money was funding and the taxes the fat profits were generating. The Fed was golden, and its no-lean paradigm was vindicated.
Then suddenly in 2007, thousands of homeowners with adjustable rate mortgages (ARMs) began to default on their loans and the bubble officially imploded. The negative effects of the imploded bubble sent disruptive waves across the U.S. and global economies and exposed the depths of the financial crisis which began unwinding in 2008.
Most stimulus regulation has been slow to take hold, and what meager progress has been made (see the ill-fated Troubled Asset Relief Program, for one example) remains overshadowed by the enormity of the tasks yet to be solidly tackled. The optimistic forecasters predict a tepid long-term recovery. The more realistic-minded pundits see our recovery following a line closer to the decades-long and still-present stagnation in the Japanese economy, triggered by that country’s recession in the late 1980s and its failure to address bad loans held by lenders.
With each lurch of an economic cycle, the effects of the Fed’s boom-time policy missteps will only accumulate to create deeper and longer downturns. If our best efforts at jump-starting the economy during this latest downturn only translates into a feeble recovery, what then will happen when the next financial crisis and real estate hysteria rears its ugly head?
That is the question posed by William R. White, an economist with the Federal Reserve Bank of Dallas, in his paper “Should Monetary Policy ‘Lean or Clean’?” In it, White argues against the deep-rooted notion that it is impossible to ‘lean’ against a bubble to deflate it before it implodes. He examines the necessity of the Fed’s use of monetary policy to do so rather than relying on their monetary policy to merely ‘clean’ up the detritus of an imploded bubble, which is where we find ourselves today.
The Fed batting clean-up
Under the clean-up monetary policy espoused by the Fed in the last several decades, asset bubbles in the credit cycle (like the real estate bubble of 2000-2005) are left to grow, relatively unhindered. Once the bubbles implode, the Fed simply eases monetary policy by reducing short-term interest rates and sitting back to allow the growth in jobs and spending to recharge. According to White, proponents of the limited clean-up policy argue that this model has worked in past recessions, and it ought to continue working in the future.
Prior to the current financial crisis, it is true that the clean-up policy did work in past Fed-induced business recessions. But as we are all well aware, the argument that something has worked in the past is no ironclad guarantee that it will continue to work in the future. Increased globalization, securitization and leveraging of assets have changed the economy and morphed into a different animal than the one the clean-up policy was intended to keep in check.
In addition, White points out that with each successive recession up to this point, the Fed has had to drop interest rates increasingly farther and faster, and leave them low longer. The current interest rate is less than 1%. There isn’t much wiggle room to 0% rates, and none at all below that. Despite the Fed’s efforts to clean up the mess of an imploded bubble with federal money management, nearly stagnant employment since 2000 and a decades-long trend of increasing household debt sees consumers’ mortgage and credit card payments eat up more and more of their actual household incomes. This effective reduction in income translates into homeowners and tenants having less money to spend and, by extension, a less vigorous real estate recovery. Obviously, the Fed’s policy of merely cleaning up after imploded bubbles of real estate pricing has very real and alarming limitations.
White proclaims it is time to consider a new monetary policy paradigm, one which would have the Fed deflating an asset-pricing bubble slowly rather than allowing it to grow and eventually implode to destroy the ownership of real estate equities.
The brave new world needs a new paradigm
The arguments of opponents against a leaning monetary policy as reported by White are:
- Leaning on a bubble would require the Fed to target certain asset prices. How does the Fed decide which assets would be targeted?
- How can the Fed determine if an asset’s price is too high if there is no way to pinpoint a fundamental price from which to make a comparison?
- Interest rate increases used to deflate asset prices would deflate the bubble but also cause damage to other economic sectors.
The main counterargument White makes against these claims is that they mistake asset prices for excessively permissive credit conditions (a.k.a. bubbles). Asset price inflation is merely a symptom of bubbles, White argues, not a cause of them. Reining in unchecked growth would tighten credit and control growth, effectively and automatically ‘targeting’ the future of over-inflated prices. Similarly, the economy need not implode for want of growth – again, credit would not be removed, merely tightened to dampen speculation and prevent an overly onerous price correction.
Bringing the message home
Applied to real estate, a leaning monetary policy would not simply set a ceiling on the growth of housing prices. Instead, access to easy mortgage credit would be tightened to prevent price increases unsupported by inflation and demographic demands for housing and commerce. Interest rate movements do drive real estate prices in an inverse direction.
During this last boom phase the price of housing, as well as other real estate, was broken up into three components:
- an inflationary component;
- a demographic or appreciation component; and
- a speculative or bubble gain component.
The inflationary component is the increase in the price of property above its value in the past. This component is controlled by the Fed’s inflation target, and represents the amount of inflation present in the property’s price required to stave off the ever-present threat of deflation. Historically, this healthy rate of inflation is 2-3%.
The demographic or appreciation component is determined by real estate market fundamentals found in the surrounding population. This component of the price is determined by the demographic situation enveloping a property. Are the inhabitants of this neighborhood experiencing an increase in population density or income, or is the density or income falling? Is the property well-situated (away from noise, traffic, etc.)? Has the property been substantially improved? Have other properties in the neighborhood been substantially upgraded to make the neighborhood more desirable — appreciated? These principles, forsaken during the apex of the 2005 housing glut, are the most stable indicators of a property’s long-term value.
The last component is the pernicious and flighty speculative component (or what we will call bubble gain) component of property pricing. Bubble gain is a product of speculators with uncontrolled access to loose credit who recklessly bid up property prices. Hence, the speculative bubble gain is the artificial and unsustainable component of the price. Typically, bubble gain occurs when property prices exceed their inflationary and demographic components and steadily accelerate for longer than 12 to 24 months.
Instead of letting the real estate bubble of 2005 implode as it did under the clean-up policy, the Fed, having seen it coming, could have leaned against the bubble. It could have pre-empted the implosion and eased the fallout from speculation for the housing market — and thus, the entire economy — by:
- raising interest rates affecting mortgages;
- changing appraisal valuation calculations;
- prohibiting no-income, no-doc loans;
- prohibiting misleading teaser rates on ARMs;
- barring negative amortization schedules;
- with the help of Congress, requiring the annual percentage rate (APR) under the Truth in Lending Act (TILA) to be based on the note rate, and not a teaser rate;
- raising the minimum downpayment on purchase-assist loans with the Federal Housing Administration’s assistance;
- encouraging Congress to reduce the tax benefits of homeownership to temporarily make housing less attractive; and
- forbidding the use of home equity lines of credit (HELOCs) for consumer purposes, depriving owners of the ability to pull all the equity out of their homes without selling the property.
While these steps do not directly cap the price of homes or control ownership, they effectively reel in the amount of credit demanded or available in the mortgage pool and hence decrease the ability of homebuyers and speculators to continue driving up home prices to create the speculative price component. As White suggests, this leaning policy would have potentially stopped the unnatural acceleration of prices and created less mess for the Fed to clean up — and for the nation’s taxpayers to bankroll. Consider the possible relief to the construction, mortgage financing, real estate sales and real estate-affiliated services industries if the Fed had leaned, rather than cleaned.
The difficulty of change
One of the biggest hurdles to leaning monetary policy, both in the national economy and California’s real estate economy, will be the political unpopularity of moderation in a rising (and thus profitable) market. As seen in the events leading up to the current financial fallout, those gatekeepers of the economy and real estate failed in their duty to protect not only consumers, but also their own source of revenue.
The federal administration and political powers that be must cease the kowtowing to Wall Street financiers. They must return to working in concert with the Federal Reserve and Congress to break the cycle of ever-worsening financial crises. When money is too plentiful for mortgages and speculators and the Fed leans on the emerging housing bubble by raising interest rates and tightening lending parameters, the government must pull back on spending and Congress must cut out tax breaks for as long as necessary to bring the market under control. Conversely, when the market is weakened by a recession, the government must spend and Congress must encourage ownership with tax breaks as the Fed lowers interest rates. Only when there is harmony in this triumvirate force can we avoid financial crises and effectively manage the economic future of the country.
Even as regulators and over-excited media begin to blissfully tout the end of the current financial crisis, it is more important than ever for the public — especially agents and brokers whose livelihoods are so dependent on a stable and enduring real estate market —to learn about and understand monetary policy. Only then can we protect the hard-won and dearly-priced recovery we now see coming.