Federal Reserve Policy and the Housing Bubble

Federal Reserve Policy

and the Housing Bubble

Lawrence H. White

The U.S. housing bubble and the fallout from its bursting are not

the results of a laissez-faire monetary and financial system. They hap-

pened in an unanchored government fiat monetary system with a

restricted financial system.

What Happened and Why?

Our current financial turmoil began with unusual monetary poli-

cy moves by the Federal Reserve System and novel federal regulato-

ry interventions. These poorly chosen public policies distorted

interest rates and asset prices, diverted loanable funds into the wrong

investments, and twisted normally robust financial institutions into

unsustainable positions. There is no doubt that private miscalculation

and imprudence have made matters worse for more than a few insti-

tutions. Such mistakes help to explain which particular firms have

run into the most trouble. But to explain industry-wide errors we

need to identify price and incentive distortions capable of having

industry-wide effects.

Here I will make two main points. First, the Federal Reserve’s

expansionary monetary policy supplied the means for unsustainable

housing prices and unsustainable mortgage financing. Elsewhere

(White 2008) I have discussed the growth in regulatory mandates

and subsidies that exaggerated the demand for riskier mortgages,

most importantly the implicit guarantees to Fannie Mae and Freddie

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reserved.

Lawrence H. White is the F. A. Hayek Professor of Economic History at the

University of Missouri-St. Louis.

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Mac that combined with HUD’s imposition of “affordable hous-

ing”mandates on Fannie and Freddie to accelerate the creation of a

market for securitized subprime mortgages.

Second, the Federal

Reserve has undertaken self-initiated new lending roles that consti-

tute a shadow bailout program more than twice the size of the

Treasury’s $700 billion bailout program. There is unfortunately little

evidence that the Fed’s new lending has helped to resolve our finan-

cial problems, rather than to delay their resolution.

The Credit Supply Bubble

Some authors, considering the relationship of Federal Reserve poli-

cy to asset bubbles, ask only: Should the Fed actively burst a growing

bubble? If so, how? As posed, their questions suggest that asset bubbles

arise independent of monetary policy, and the only Fed role to be dis-

cussed is that of bubble-buster. A more important pair of questions is:

Does Fed policy as currently conducted tend to inflate assets bubbles?

If so, how can we reformulate policy to avoid that tendency? Call our

objective a non-bubble-prone or “non-effervescent” monetary policy.

The economics profession has not reached a consensus on what the

optimally non-effervescent monetary policy is, but it is now widely

agreed that it isn’t holding interest rates too low for too long. It should

also now be clear that a Fed policy that deliberately ignores asset prices,

as though consumer prices alone were a sufficient indicator of excessive

Fed expansion, is also not the way to avoid inflating asset bubbles.

In the recession of 2001, the Federal Reserve System under

Chairman Alan Greenspan began aggressively expanding the U.S.

money supply. Year-over-year growth in the M2 monetary aggregate

rose briefly above 10 percent, and remained above 8 percent entering

the second half of 2003. The expansion was accompanied by the Fed’s

repeatedly lowering its target for the federal funds (interbank

overnight) interest rate. The Fed funds rate began 2001 at 6.25 per-

cent and ended the year at 1.75 percent. The Greenspan Fed reduced

the rate further in 2002 and 2003, pushing it in mid-2003 a record low

of 1 percent, where it stayed for a year. The real Fed funds rate was

negative—meaning that nominal rates were lower than the contem-

porary rate of inflation—for an unprecedented two and a half years.

A borrower during that period who simply purchased and held vacant

The discussion of Fed policy in the next section also draws on White (2008).

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land, the price of which (net of taxes) merely kept up with inflation,

was profiting in proportion to what he borrowed.

How do we judge whether the Fed expanded more than it should

have? One venerable (albeit no longer popular) norm for making fiat

central bank policy as neutral as possible toward the financial market

is to aim for stability (zero growth) in the volume of nominal expendi-

ture. In the equation of exchange, MV=Py, nominal expenditure is MV

or equivalently Py. Stability of MV implies that the Fed should not

inject money through the financial market to offset growth in real out-

put (y) due to increasing productivity. Instead it should allow consumer

goods prices to fall when productivity gains reduce the costs of produc-

tion (see Selgin 1997). Second-best to stability of nominal expenditure

would be a predictably low and steady growth rate. One useful meas-

ure of nominal expenditure is the dollar volume of final sales to domes-

tic purchasers (GDP less net exports and change in business

inventories). During the two years from the start of 2001 to the end of

2002, final sales to domestic purchasers grew at a positive but moder-

ate compounded rate of 3.6 percent per annum. During 2003 the

Fed’s expansion of demand began to show up: the growth rate jumped

to 6.5 percent. For the next two years, from the start 2004 to the end

of 2005, the growth rate was even higher at 7.1 percent, nearly a dou-

bling of the initial rate. It then backed off, to 4.3 percent per annum

from the start of 2006 to the start of 2008. But the damage from an

unusually rapid expansion of nominal demand had been done.

A widely used norm for Fed policy is the “Taylor Rule,” a formula

devised by economist John Taylor of Stanford University. The Taylor

Rule offers a method of estimating the level of the federal funds rate that

would be consistent (conditional on current inflation and real income)

with keeping the economy’s price inflation rate to a chosen target rate.

From early 2001 until late 2006 the Fed kept the federal funds rate on

a path well below the estimated rate that would have been consistent

with targeting a 2 percent inflation rate (the highest rate within the

Bernanke Fed’s declared “comfort zone”). A fortiori the Fed held the

actual rate even farther below the path consistent with targeting stabili-

ty in nominal income. In its monthly publication Monetary Trends, the

Federal Reserve Bank of St. Louis plots the estimated range of federal

funds rates that would be consistent with inflation rates of 0 to 4 percent.

Federal Reserve Bank of St. Louis FRED database, Series FSDP, Final Sales to

Domestic Purchasers, http://research.stlouisfed.org/fred2/series/FSDP?cid=106.

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Its plots show that the Taylor-rule gap was especially large—200 basis

points or more—from mid-2003 to mid-2005.

Alan Greenspan has pled innocent to the charge of having overex-

panded and created a credit bubble, on the grounds that (1) the

housing price bubble was worldwide, thus the growth of U.S. credit

must have reflected a global savings glut, and (2) the monetary base

and M2 weren’t growing rapidly. There appears to be a grain of truth

to the hypothesis that growth in the global supply of loanable funds

to the U.S. market pushed down U.S. real interest rates. Real 30-year

mortgage rates in the United States, largely beyond the influence of

Federal Reserve policy, did fall. Nominal 30-year rates fell by 113

basis points between 2001 and 2004 while the inflation rate fell only

15 basis points. As noted above, however, the Fed lowered the fed-

eral funds rate much more, by 525 basis points, indicating a major

amplification of cheap credit by Fed policy. M2 growth, as noted

above, in fact remained unusually high for at least two years.

Consequently, Greenspan’s claim that money growth was slow can-

not be substantiated.

The dramatic lowering of short-term interest rates not only fueled

growth in the dollar volume of mortgage lending, but had unintend-

ed consequences for the type of mortgages written. By pushing very-

short-term interest rates down so dramatically between 2001 and

2004, the Fed lowered short-term rates relative to 30-year rates.

Adjustable-rate mortgages (ARMs), typically based on a one-year

interest rate, became increasingly cheap relative to 30-year fixed-rate

mortgages. Back in 2001, nonteaser ARM rates on average were 113

basis points cheaper than 30-year-fixed mortgage rates (5.84 percent

vs. 6.97 percent). By 2004, as a result of the ultra-low federal funds

rate, the gap had grown to 194 basis points (3.90 percent vs. 5.84 per-

cent).

Not surprisingly, increasing numbers of new mortgage bor-

rowers were drawn away from mortgages with 30-year fixed rates

into one-year ARMs. The share of new mortgages with adjustable

rates, only one-fifth in 2001, had more than doubled by 2004. An

adjustable-rate mortgage shifts the risk of a rise in interest rates from

Federal Reserve Bank of St. Louis Monetary Trends (February 2008): 10. The

Taylor Rule formula used there is spelled out on p. 19. The inflation measure is the

Fed’s currently preferred measure, the Personal Consumption Expenditure defla-

tor. John Taylor noted the Fed’s deviation from the Taylor Rule in his 2007 Jackson

Hole Symposium paper (Taylor 2007).

As reported by Freddie Mac: www.freddiemac.com/pmms/pmms30.htm.

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the lender to the borrower. Many borrowers who took out ARMs

implicitly (and imprudently) relied on the Fed to keep short-term

rates low for as long as they kept the mortgage. As is well known, they

have faced problems as their monthly payments have reset upward.

The shift toward ARMs compounded the mortgage-quality problems

arising from other sources such as regulatory mandates.

Because real estate is an especially long-lived asset, and thus has an

especially large part of its value depend on the discounting of far-distant

future cash flows, its market value rises relative to those of other assets

with a fall in the interest rate used for discounting. The dramatic fall in

interest rates made 2001 real estate prices seem like bargains. The

demand bubble that the Fed created was thereby drawn disproportion-

ately into real estate. Real-estate loans at commercial banks grew at a

12.26 percent compound annual rate during the period from the mid-

point of 2003 to the midpoint of 2007.

The Fed-fueled low interest rates

and growth of mortgage credit pushed up the demand for and prices of

existing houses, and encouraged the construction of new housing on

undeveloped land. The housing sector thus exhibited a disproportionate

share of the price inflation predicted by the Taylor-rule gap.

Researchers at the International Monetary Fund have provided evi-

dence from simulation studies corroborating the view that the Fed’s

easy-credit policy (combined with encouragements for riskier mortgage

lending) inflated the housing bubble. As they put their findings, “the

unusually low level of interest rates in the United States between 2001

and 2003 contributed somewhat to the elevated rate of expansion in the

housing market, in terms of both housing investment and the run-up in

house prices up to mid-2005.” After estimating the sensitivity of U. S.

house prices and residential investment to interest rates, they find that

“the increase in house prices and residential investment in the United

States over the past six years would have been much more contained

had short-term interest rates remained unchanged” (Cardarelli et al.

2008: 19, 21).

Even Alan Greenspan, who otherwise protests his inno-

cence, has acknowledged that “the 1 percent rate set in mid-2003…

lowered interest rates on adjustable-rate mortgages [ARMs] and may

have contributed to the rise in U.S. home prices” (Greenspan 2007).

Author’s calculation from data in the Federal Reserve Bank of St. Louis FRED

series REALLN.

Taylor (2007) arrives at similar findings after running slightly different counterfac-

tual simulations.

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The excess investment in new housing has left the United States

today with an overbuilt housing stock. Assuming that the federal gov-

ernment does not follow proposals (tongue-in-cheek or otherwise)

that it should buy up and then raze excess houses and condos, or pro-

posals to admit a large number of new immigrants, we can expect

U.S. house prices and construction activity to remain depressed for a

few years. The process of adjustment, already well under way but not

yet completed, requires house prices to fall and resources (labor and

capital) to be released from the construction industry to find more

appropriate employment elsewhere. Correspondingly, it requires the

book value of existing financial assets based directly or indirectly on

housing to be written down and resources to be released from writ-

ing and trading mortgages to find more appropriate employment

elsewhere. No matter how painful the adjustment processes, delay-

ing them only delays the economy’s recovery. Going forward, barring

a more fundamental reform of the monetary regime, a monetary pol-

icy rule that incorporates asset prices in the measure of inflation may

offer the best prospects for reduced asset froth.

The Federal Reserve’s New Post-Bubble Roles

As a historian of antiquarian monetary institutions, let me take

you back to what now seems like the distant past: 2007.

Before 2008, the Federal Reserve System played the tradition-

al central banking roles of conducting monetary policy and (on

very rare occasions, like the day after 9/11) acting as a “lender of

last resort.” Monetary policy means controlling the quantity of

money in pursuit of economic objectives. Acting as a lender of last

resort is merely an aspect of monetary policy: It means injecting

reserves into the commercial banking system to prevent the quan-

tity of money from contracting—and thereby to protect the econ-

omy’s payment system—when there is an “internal drain” of

reserves (bank runs and the hoarding of cash). The “lender” part

of the role’s name has long been an anachronism. Central banks in

sophisticated financial systems discovered many decades ago that

they can inject bank reserves without lending, by purchasing gov-

ernment securities in the open market. By purchasing securities

the central bank supports the money stock while avoiding the dan-

ger of favoritism associated with making loans to specific banks on

noncompetitive terms (Goodfriend and King 1988). By purchasing

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Treasury securities it avoids the potential for favoritism in purchas-

ing other securities.

Before 2008, the Federal Reserve controlled growth in monetary

and credit aggregates through such open market operations, using

the Fed funds interest rate as an intermediate target for guiding

open market operations. Growth in the monetary aggregate that the

Fed directly controls, the monetary base, was matched almost exact-

ly by the Fed’s accumulation of U.S. Treasury securities, virtually the

only financial asset the Fed acquired. The quantity of loans that the

Fed made to commercial banks was trivial (less than $0.5 billion at

the end of 2007, on a balance sheet of $800 billion). Loans to non-

bank institutions were out of the question.

In 2008 things changed in a remarkable and worrisome way. In addi-

tion to conducting monetary policy, the Fed took on the new role of

selectively channeling credit in favored directions. It now makes loans

to, and purchases assets from, an array of financial institutions that are

not commercial banks and do not issue means of payment. The total of

new Fed credits granted—the Federal Reserve’s self-financed bailout

program—stood by the end of 2008 at $1.7 trillion, more than double

the size of the Treasury’s $700 billion bailout authority.

The Fed’s weekly balance sheets contain a number of new line

items reflecting its newly assumed role as credit allocator.

The list of

items appearing on the balance sheet in early 2009, but absent from

it in 2007, begins with Mortgage-backed Securities, an entry that first

began appearing on the release of January 15 and has grown steadi-

ly since. On the balance sheet release of February 5, 2009 (the most

recent available at the time of this article’s final revision), the Fed’s

holdings of MBSs stood at $7 billion. Second is Term Auction Credit

of $413 billion, representing 28-day and 84-day loans to banks.

Previously loans to commercial banks were basically overnight cred-

its for meeting reserve requirements. Banks were expected to secure

longer-term loans from depositors or other private lenders. Third on

the list is Primary Dealer and other Broker-Dealer Credit of $30 bil-

lion, loans to securities dealers. Previously the Fed did not lend to

securities dealers. Fourth is the Asset Backed Commercial Paper

The Fed’s latest balance sheet is reported weekly, with comparisons to one week

and one year ago, in the Fed’s H.4.1 release, available at www.federalreserve.gov/

releases/h41. For a detailed discussion of the 23 October 2008 balance sheet, see

Hamilton (2008). Each dollar figure reported in the present text is the average of

daily figures for the week ended 4 February 2009.

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Money Market Mutual Fund Liquidity Facility at $17 billion, loans

to banks or bank holding companies for the specific purpose of allow-

ing them to purchase assets from money market mutual funds that

are facing redemptions. Previously money-market funds that needed

to sell commercial paper were expected to sell it in the money mar-

ket. Fifth, Credit Extended to American International Group, Inc.,

life-support loans to the failed insurance giant, amounted to $39 bil-

lion. Previously the Fed did not lend to insurance companies, nor to

financial firms in receivership.

Sixth comes Net Portfolio Holdings of Commercial Paper Funding

Facility LLC, an entry that the H.4.1 release describes as loans to “a

limited liability company formed [by the Federal Reserve Bank of

New York in October 2008] to purchase three-month U.S. dollar-

denominated commercial paper from eligible issuers and thereby fos-

ter liquidity in short-term funding markets and increase the

availability of credit for businesses and households.” Previously the

Fed did not purchase commercial paper or other private securities.

Seventh, holding a place on the balance sheet although it had yet to

show a non-zero amount, we find Net Portfolio Holdings of LLCs

Funded through the Money Market Investor Funding Facility, a sim-

ilar entry for loans to “a series of limited liability compa-

nies…established [by the NY Fed in November 2008] to purchase

short-term U.S. dollar-denominated certificates of deposit, bank

notes, and outstanding asset-backed commercial paper from eligible

issuers.” Eighth through tenth are: Net Portfolio Holdings of Maiden

Lane LLC, an entry representing troubled assets from the portfolio of

the former investment bank Bear Stearns that the New York Fed

absorbed to sweeten the takeover deal for the benefit of JPMorgan

Chase; Net Portfolio Holdings of Maiden Lane II LLC, representing

troubled mortgage-backed securities purchased from AIG, and Net

Portfolio Holdings of Maiden Lane III LLC, representing troubled

collateralized debt obligations purchased from AIG. By holding

rather than selling off these assets the Fed is speculating that the mar-

ket for selling the assets will be better later on. Previously the Fed did

not get involved in financial mergers, acquisitions, or life-support

operations by taking on troubled assets. The FDIC did, but only in

mergers between two insured commercial banks. Bear Stearns was an

investment bank, not an insured commercial bank. AIG is an insur-

ance company that no other private firm wants to take over.

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In September 2008, the Federal Reserve began buying federal

agency notes—short-term IOUs of Fannie Mae, Freddie Mac, and

the Federal Home Loan Banks—from securities dealers. As of 5

February the Fed was holding $29 billion of such notes, where it

held $0 one year ago, though it has held agency debt in the past. Fed

loans to commercial banks (listed as primary, secondary, and season-

al credit) are currently at $67 billion, up from only $0.15 billion a

year ago. In total, the Fed’s assets have more than doubled in a year’s

time, from $874 billion in February 2008 to an astounding $1,853 bil-

lion in February 2009.

Meanwhile, off the balance sheet (but recorded as a “memoran-

dum item”), the Fed also runs a Term Securities Lending Facility

that has swapped $120 billion of its Treasury securities to broker-

dealers in exchange for less liquid securities including “highly rated”

mortgage-backed securities. Subtracting the swapped-out Treasuries

from its balance sheet holdings, the Fed’s assets in February 2009

were only 19 percent Treasuries, down from 82 percent one year ear-

lier. Some of the new assets are loans collateralized by mortgage-

backed securities, while others have better collateral, but none are as

safe as Treasuries. The Fed looks increasingly like a very highly lever-

aged hedge fund. In the February figures the Fed’s equity cushion

was down to only 2.2 percent of its assets, so it was leveraged more

than 45:1. A year earlier, with a much safer portfolio, the Fed’s equi-

ty ratio was nearly twice as high at 4.3 percent.

Reflecting the riskiness of some of its new assets, the Fed in

October 2008 recorded $2.7 billion in losses from mark-downs on the

securities held in the New York Fed’s Maiden Lane, LLC account

(see Hamilton 2008). The book value of the Fed’s overall capital

dropped by $2 billion in the week between 15 October and 22

October, sliding to $40 billion from $42 billion.

The Federal Reserve’s new interventions into financial markets

over the past year have proceeded at its own initiative, without prece-

dent, and without congressional oversight. None of the new lending

facilities has anything to do with acting as a lender of last resort in the

traditional sense of preventing a reduction in bank reserves due to

bank runs, or a reduction in the deposit-to-reserves ratio, from

shrinking the money stock. Any desired volume of bank reserves can

be injected entirely by purchasing Treasury securities. Through all

the recent turmoil there has been no shrinking money stock, and

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only one brief run on a commercial bank (Indy Mac). Investment

banks do not issue checking deposits, are therefore not subject to

depositor runs, and are not part of the payment system. Neither are

securities dealers. Money-market funds have a limited payment role

but have no demandable debts, and therefore are not subject to self-

aggravating me-first runs. The Fed’s expansions of its lending activi-

ties have had nothing to do with protecting the payment system or

stabilizing the money supply.

The Fed’s new activities instead amount to a grab-bag of ad hoc

bailouts. They seem to aim at protecting banks and nonbanks from

the consequences of holding portfolios overweighted with mortgage-

backed securities, or derivatives based on such securities, while

keeping levels of capital inadequate for such portfolios. Attempting

such bailouts is a worrisome role for the Fed to take on, especially at

its own initiative, without oversight. That the Fed’s bailout is “self-

financed” by expanding its own liabilities (“printing” new money)

does not mean that it provides a free lunch. It is ultimately financed

by the Fed’s power to levy an implicit tax on dollar-holders, putting

us all at risk of inflationary depreciation of the dollar.

Thus far, because it has not required an appropriation from

Congress, the Fed’s bailout efforts seem to be enjoying the complete

freedom from oversight that Secretary Paulson initially sought for

the Treasury’s bailout. That should change. No matter how urgently

we seek to avoid a financial meltdown, there is no good reason to

embrace a constitutional meltdown. It is time for a public debate on

the wisdom of the Fed’s remarkable departure from its traditional

roles. Would calling the Fed to account for its actions be a violation

of the Fed’s traditional independence? Unfortunately Chairman

Bernanke forfeited that independence months ago.

References

Cardarelli, R.; Monacelli, T.; Rebucci, A.; and Sala, L. (2008) “The

Changing Housing Cycle and the Implications for Monetary

Policy.” In World Economic Outlook: Housing and the Business

Cycle, Chap. 3. Washington: World Bank (April).

Goodfriend, M., and King, R. G. (1988) “Financial Deregulation,

Monetary Policy, and Central Banking.” In W. S. Haraf and R.

Kushmeider (eds.) Restructuring Banking and Financial Services

in America. Washington: American Enterprise Institute.

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Greenspan, A. (2007) “The Roots of the Mortgage Crisis.” Wall

Street Journal (12 December).

Hamilton, J. D. (2008) “The Federal Reserve’s Balance Sheet.”

Econbrowser blog (25 October): www.econbrowser.com/

archives/2008/10/the_federal_res.html.

Selgin, G. (1997) Less than Zero: The Case for a Falling Price Level

in a Growing Economy. London: Institute of Economic Affairs.

Taylor, J. B. (2007) “Housing and Monetary Policy.” Paper present-

ed at the Federal Reserve Bank of Kansas City Symposium on

“Housing, Housing Finance, and Monetary Policy.” Jackson Hole,

Wyo. (30 August–1 September). Available at www.kc.frb.

org/PUBLI CAT/SYMPOS/2007/PDF/Taylor_0415.pdf.

White, L. H. (2008) “How Did We Get into This Financial Mess?”

Cato Briefing Paper, No. 108 (18 November).

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