By Oxford Analytica - 09/05/07 07:08 PM EDT
Leading U.S. economists presented many different views of the current situation, but growing agreement emerged over two points: that swift and strong U.S. Federal Reserve action is needed to avoid recession, and that at least some blame attaches to Fed policies under its former chairman, Alan Greenspan.
Each year the U.S. Federal Reserve holds a conference on economic policy at Jackson Hole featuring many leading Fed and U.S. academic economists. This year the symposium was devoted to the topical issue of the role of the housing market for monetary policymakers. After Fed Chairman Ben Bernanke’s largely unrevealing address on Friday, key participants offered their views over the weekend on the current state of the U.S. economy and the path by which this was reached.
BernankeIn his speech, Bernanke discussed the current financial market position and the changing role of housing markets in monetary policy transmission. In neither case did he give a clear indication of future policy, although markets took some reassurance from his performance:
•Financial markets. Bernanke surveyed the recent history of sub-prime mortgages, highlighting the 13.5 percent delinquency rate reached in June this year for those with adjustable rates, and the impact on the market in commercial paper. He attributed the contagion to a change in risk perceptions, and stressed that the Fed had no mandate to bail out lenders or borrowers.
•Housing markets. Bernanke identified a key market failure as responsible for the higher levels of risk. While lending banks have strong incentives to monitor the quality of their assets, the growth of securitization has created a distance between the loan originators and those holding the resulting assets. The current problems reflect the “failure of investors to provide adequate oversight of originators” — and this is a problem that markets rather than regulators must and will solve over time.
•Policy pointers. Two parts of Bernanke’s analysis suggest support for Fed rate cuts. First, he emphasized the need to act if market problems threaten the real economy. Second, and perhaps more tellingly, he stressed that the Fed will pay more heed to information from “business and banking contacts” since “economic data bearing on past months or quarters may be less useful than usual for our forecasts.” This opens the way to pre-emptive policy action before substantial negative data is accumulated — as will be the case for some time.
Housing and Monetary policyA number of leading economists presented their views on the implications for monetary policy of recent housing market movements. Two stand out:
Martin Feldstein. The Harvard professor and president of the National Bureau for Economic Research (NBER) gave probably the most negative assessment of the current situation:
•The value of housing wealth more than doubled from 1999 to 2006, reaching $21 trillion.
•The last 12 months saw an average price decline of 3.4 percent, with the most recent data suggesting a threefold acceleration.
•Home-building has fallen 20 percent to a 10-year low.
Feldstein sees risks that the fall in house prices and construction activity could cause a full recession directly; that a fall in mortgage refinancing and home equity loans could exacerbate the consumption decline; and that the sub-prime crisis has frozen credit markets, posing difficulties for business investment and activity. He referred in particular to another paper, presented by Ed Lamear, that found construction falls as a precursor in eight out of 10 recessions.
Frederic Mishkin. The Fed governor and respected academic economist offered a much more detailed analysis of the situation and, in particular, of the implications for consumption of falling house prices. He distinguishes in the academic literature between two views:
•Older theory. This largely supports the view that housing wealth should be treated like any other source of wealth. The Fed model relies on a long-run marginal propensity to consume housing or any other wealth of around 3.75 percent — that is, for each additional dollar of wealth, consumption rises by 3 3/4 cents.
•Recent analyses. More recent empirical analyses tend to imply stronger effects of housing wealth. Mishkin highlights a range of recent studies, with different approaches, time-frames and country samples, all showing that housing wealth has an impact around twice as strong as that of other (e.g., stock market) wealth.
Mishkin’s own simulations show that the importance of housing for macroeconomic outcomes demands a stronger response from policymakers to falling house prices. The “optimal” Fed response is much quicker and stronger than that predicted by a “Taylor rule” (a standard rule indicating the preferred interest rate relative to some neutral level, in response to off-target inflation and unemployment). Crucially, Mishkin’s optimal response requires that policymakers react before output falls — rather than waiting to see this in the data.
ProspectsIn general, the mood at Jackson Hole seems to have been a somber one, with most participants expecting considerable economic weakening. The bearish Robert Shiller talked in his paper of a potential 50 percent decline in real house prices.
Feldstein estimates a decline of 20 percent in nominal house prices (wiping out around $4 trillion in wealth) could trigger a consumption fall of 1.5 percent of GDP. Given that only consumption kept GDP growth positive in the fourth quarter of 2006 and the first quarter of 2007, this would almost inevitably imply a recession.
It seems certain now that a large Fed response is forthcoming:
•Mishkin is a long-standing research collaborator with Bernanke, and the former’s findings that policymakers should act before output data shows a fall seem directly in line with Bernanke’s comments that the Fed should respond before data is available.
•Both Bernanke and Mishkin also highlighted evidence that economies with more “sophisticated” mortgage markets (of which the United States is the leader) see a higher correlation between housing wealth and consumption, and it seems likely that the Fed chairman is deeply concerned about the likely consumption effects of the housing market decline.
Is Greenspan to blame?A final outcome from the symposium was a broader sense that previous Fed policy had contributed to the housing market bubble. While no participants specifically named former Fed Chairman Alan Greenspan, the criticism was clear in a number of papers — none more so than that of Professor John Taylor of Stanford University, author of the “Taylor rule.” His analysis demonstrated that a policy that followed his rule would have resulted in much higher Fed funds rate through 2003-05, and further, that this would have significantly reduced the size of the housing market bubble (and presumably also its eventual bursting).
While other participants were more careful, the sentiment is clearly widely shared that the Fed is partly to blame for the housing bubble and the economic impact to come — notwithstanding the role of investors as highlighted by Bernanke.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com .