Monetary Policy and the Housing Bubble

[Joanne98]

posted by Adam Levitin
A popular explanation of the financial crisis lays the blame at the feet of the Federal Reserve for lax monetary policy. In this story, the Fed dropped interest rates starting in 2001 and kept rates too low for too long. Low rates induced an orgy of mortgage borrowing for leveraged home speculation.

It's a nice story. Only problem is it doesn't really hold up under inspection. Low rates in 2001-2003 did fuel an amazing mortgage refinancing boom, but not a purchase boom, and the boom was mainly in conventional fixed-rate mortgages, not the exotic products later years. Moreover, despite the refinancing boom, no housing bubble was emerging in this period.

The Fed started to raise rates in mid 2004 and continued to do so until mid-2006. It was during this period that the bubble emerged, when rates were going up. (To be fair, some might argue for an earlier date to the bubble, even as far back as the late 1990s.) If we date the bubble from 2004, it's not consistent with a rate-driven bubble story, although rates were still extremely low in absolute terms during this period.

The monetary policy story, however, really falls apart when one compares the US and Canada, as the graph below does. Canadian interest rates, and perhaps more importantly, Canadian mortgage rates, track US rates pretty closely. Yet the US had a housing bubble, and Canada did not. This means we have to look somewhere other than monetary policy to explain the housing bubble. The answer, I believe, lies in method and regulation of housing finance.

Continued>>>
http://www.creditslips.org/creditslips/2010/02/monetary-policy-and-the-housing-bubble-debunked-1.html#more

[Taitertots]

1. His dismissal of the role of monetary policy is unwarranted

And based on insufficient evidence.

Canada didn't have the same effects because they have different regulations for mortgage securitization. The Fed was still setting the rate too low, feeding the housing bubble and the MBS bubble.