The Fed and housing –

The market is looking for clear signs of what the Fed will do in the coming months in response to the deteriorating housing market. Unfortunately, the signs of what can be done to deal with a housing slide are poor. While the Fed funds futures is pricing with certainty that the Fed will cut at least 25 bps in September, it is not clear what will happen over the longer-run. The important question is what the Fed is thinking about housing. Put differently, what is the Fed reaction function to factors other than inflation and growth? The uncertainty concerning housing and the Fed is actually threefold. First, the link between housing and economic growth is unclear. Second the link the between monetary policy and housing is also unclear. Third, it is unclear what help the Fed wants to give.

We do not have much to go on from reading Fed minutes and because the housing crisis is a special situation we do not have past precedent on what the Fed will do. Comments from Chairman Bernanke have been mixed. Up until recently, wording has focused on inflation and that the Fed would not bail-out market sectors or change their behavior because of loses by some investors. However, the August credit crisis changed everything. The Fed was willing to provide liquidity and the Chairman has commented that the Fed stands ready to provide liquidity in a crisis; however, the issue of how the Fed will deal with the root cause, the housing market slide, has been more uncertain.

After the Jackson Hole conference, we do have new insight on what the Fed is thinking through the research paper, “Housing and the Monetary Transmission Mechanism” by Frederic Mishkin. Given his position in the Fed, this is an influential paper. He provides a long discussion on the link between housing and monetary transmission. He works through the impact of rate changes and changes in user costs, housing appreciation, supply, wealth effects, and the credit channel. Acknowledging that the transmission mechanism is uncertain, he shows that the impact on housing from a change in monetary policy can be significant relative to its overall size in the economy. The high level of uncertainty is associated with the variable wealth effect between the value of housing and a consumer’s willingness to spend. The uncertainty link means that the Fed cannot truly anticipate what will happen if there is a prolonged and significant decrease in housing prices.

Given this uncertainty, the reaction for the Fed to stabilize the economy from a deep decline in housing would have to be a sustained decline in interest rates. Since the link between a change in rates and housing is uncertain, the decrease in rates would have to strong and occur quickly to address a potential decline in growth. A weak response will have limited impact.

This paper provides the best current thinking by the Fed on housing and monetary policy, yet it has some troubling conclusions. We do not know what will be the impact on the overall economy from a sustain fall in housing prices. We are not sure what the Fed could do other than that it will require a significant decline in rates to change a declining price path. This does not even address the question whether the Fed has the resolve to cut rates dramatically. Nevertheless, extrapolating from this paper suggests that we may see deep rate cuts to address a worsening problem.