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Lansner: Could huge Fed rate hikes have prevented last housing bubble?

Lansner: Could huge Fed rate hikes have prevented last housing bubble?

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Orange County’s home sales this year got off to one of the fastest starts in 25 years. The steep cost of housing evokes memories of the housing bubble of the past decade. A recent study by the Federal Reserve Bank of San Francisco calculates that 8 points worth of Fed interest rate hikes starting in 2002 could have avoided that bubble — though it concedes that in the real economic world, such a solution was too simplistic. CINDY YAMANAKA, FILE PHOTO

What would it have taken for the Federal Reserve to prevent the housing debacle of the last decade?

Apparently, 8 percentage points of increases in the key short-term interest rates the Fed controls. Oh, and that series of rate hikes would have had to start way back in 2002.

That’s the conclusion of a recent study by researchers at the Federal Reserve Bank of San Francisco.

It’s not just a history lesson, as the economy struggles again with steep housing costs. Please don’t forget, the last time the nation got housing policy wrong – just a decade ago – the nation plunged into its darkest economic period since the Great Depression.

The study’s authors – Òscar Jordà, Moritz Schularick and Alan Taylor – do admit to several caveats. Like there isn’t simple data to make easy comparisons. So they used a century and a half of international interest rate and economic data, then layered those trends over more modern U.S. data.

Still, the San Francisco Fed researchers found the U.S. suffered unprecedented housing overvaluation in the last decade – 39 percent more than the norm by 2006, based on a post-World War II ratio of house prices to income.

Plus, the report shows the Fed’s main economic management tool – interest rate policy – doesn’t have a quick impact on real estate.

For example, after a 1 percentage point increase in short-term rates, “initial impact is quite muted.” But by the fourth year, mortgage lending as a share of gross domestic product has fallen by 2.8 percent, and the ratio of house prices to income per capita is down by 4.4 percent.

Using those historical trends – a 39 percent overvaluation in 2006 and a 4.4 percent cut in the house-to-income ratio four years after a 1-point rate hike – the researchers concluded the Fed might have prevented the bubble with 8 points of rate hikes starting in 2002.

That would have been an interest rate increase the nation had not seen since the early 1980s, when sharp rises created a painful recession but broke a long-running bout of high inflation.

However, the San Francisco researchers noted this rate-hike solution is too simple.

Early rate hikes by the Fed might have signaled a warning about asset bubbles in general. Plus, the initial rate hikes might have cooled housing to the point where house hunters weren’t in a buying frenzy and real estate’s overvaluation wasn’t a huge problem. So the full 8 percent hike might never happened.

Perhaps more problematic was the notion that this intense level of rate hikes would have cooled the economy, probably into a recession. That broad dip in the national business climate could have further tempered real estate’s upswing.

“What is the takeaway then?” the report says. “Slowing down a boom in house prices is likely to require a considerable increase in interest rates, probably by an amount that would be widely at odds with the dual mandate of full employment and price stability. Moreover, the Fed would need a crystal ball to foretell house price booms. In restraining asset prices, while the power of interest rate policy is uncontestable, its wisdom is debatable.”

Of course, the Fed would have had to see a problem to act at all, if not accordingly. Take the last real estate mess as an example:

In December 2004, with housing bubble talk heating up, researchers at the Federal Reserve Bank of New York issued a report that noted a 36 percent rise in after-inflation U.S. home prices since 1995 was double what had been seen in two previous real estate run-ups.

But, the report concluded: “We argue that market fundamentals are sufficiently strong to explain the recent path of home prices and support our view that a bubble does not exist.”

Those researchers in late 2004 believed falling interest rates and strong demand for housing – not some mania – were pushing up prices, Even at the state level, where this research revealed evidence of excessive price run-ups on each coast, the researchers would not sound any alarms.

“Volatility at the state level is the result of changing fundamentals rather than regional bubbles,” the 2004 New York Fed report said. “Nevertheless, weaker fundamentals have caused home price declines in those areas with inelastic supply. If the past is any guide, however, that phenomenon is unlikely to plunge the U.S. economy into a recession.”

That kind of thinking probably lead then-Fed boss Alan Greenspan – the reigning “maestro” of the economy at the time – to go to Congress 10 years ago and say he saw only tiny bubbles.

“Although a ‘bubble’ in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels,” his prepared testimony said. “The U.S. economy has weathered such episodes before.”

That froth eventually proved too hot for the economy to handle.

The Orange County Register – News Headlines : Real Estate News