Fed Watch: The Fed and the Housing Bubble

Tim Duy's latest Fed Watch examines the Fed's response to the potential housing bubble: Last week saw a flurry of reports about the Fed and housing.

David Wessel reported in the Wall Street Journal that the Fed is becoming concerned about a potential housing bubble. Those concerns were reiterated by Greenspan in the Q&A after Friday’s energy speech (see Calculated Risk here and here for some enlightening quotes). I don’t blame Fed officials for raising the alarm. I’m concerned, too. But the important question is what are they prepared to do about it? I continue to believe that the Fed is not likely to change the path of monetary policy to pop a housing bubble.

Bubbles pose significant challenges for policymakers. They are economic distortions that lead to inefficient resource allocation, and tend to have nasty unexpected consequences when they pop. But to what extent, if any, should they be a focus of central bank policy? I think conventional wisdom at the Fed is that you should keep your eye on the ball, and the ball is price stability. To deviate from this objective pulls you into the uncertain world of bubble analysis. It is possible that you may not be able to conclusively identify whether a bubble exists until it is far too late to do anything about it. Moreover, the Fed is not charged with maintaining stability within any one sector of the economy, just as they cannot set monetary policy with a focus on California. The Fed will instead focus on cleaning up after the bubble pops (some will argue that this entails creating a new bubble somewhere else in the economy).

Assuming that a more aggressive monetary policy is off the table for the time being, what else could the Fed do to address the housing bubble? Often, those of us following the Fed forget that it is also charged, along with a number of other agencies, with regulatory responsibilities over the financial industry. According to Wessel:

The Fed and other bank regulators, however, this week warned banks to take more care with home-equity loans, noting that such loans are "subject to increased risk if interest rates rise and home values decline."

And, from the Wall Street Journal, on the same day of Wessel’s piece:

New Mortgage Guidelines Planned: Federal banking regulators, concerned about growing risks in the mortgage market, are planning to issue new guidelines for mortgage lenders.

The new guidelines, which could be completed as soon as early next year, come at a time of growing concern that the proliferation of new mortgage products could mean higher risks to borrowers and lenders. Regulators are turning their attention to mortgages after issuing their first-ever guidelines for credit-risk management for home-equity lending this week, warning financial institutions to re-examine their loan criteria.

Note the key phrase in this piece, "early next year." The regulatory process can move at a glacial pace, so it is apparently premature to conclude that banking regulators are about to put the kibosh on the housing market. Moreover, regulators appear to be well behind the curve. See the following piece, from the same day’s WSJ!

The Letter of Credit Returns. Buy beachfront property! Almost no money down!

More investors prowling some of the hottest real-estate in the country have discovered an old-fashioned financing tool -- the letter of credit -- and are using it in a way that may be adding fuel to an already overheated housing market.

…Some say letters of credit make it too easy for speculators. Economists estimate about 20% of residential property sales involve investors, not families or individuals who plan to live in the home. Such purchasing could be artificially lifting prices and demand and could destabilize a market should speculators start dumping homes, these economists fear.

Looks like the financial industry is working overtime to keep a fire under the housing market. Does anyone out there believe that the regulators can match their pace? And, lest we forget, interest rates have returned to their "conundrum" levels (see William J. Polley). With the financial industry pushing real estate, and low interest rates ensuring cheap financing, it is tough to see that regulators have much of a chance to get a handle on this bubble without cutting it off at the knees. So, given the lack of attractive policy options, or the ineffectiveness of these options, why the very public shift in concern at the Fed? I propose a very simple answer: The Fed is trying to protect its reputation. In the past, Greenspan has clearly downplayed the existence and impact of a housing bubble, even going so far as praising ARMs. It is getting harder to make those arguments, and consequently I suspect that Greenspan does not want to be blamed for being the cheerleader behind another bubble (see Roach’s withering criticism of Fed policy here). Unfortunately, it is probably too late for that – most of us in the blogosphere have long memories. Simply put, the Fed’s recent housing market concern is interesting and important, but not by itself likely to trigger more aggressive monetary policy. Instead, it appears to be more of a CYA maneuver – use the regulatory process to strengthen (hopefully) the financial industry, tell homebuyers they are taking a risk, and hope for the best.