Wednesday, August 26, 2015

A Pre-HUD monetary regime

Yesterday, Ironman at Political Calculations made the following suggestion:
So what should the Fed do? We would suggest that the Fed do nothing, but in a creative way. The Fed should announce that it will indeed hike short term interest rates as planned in September 2015, and at the same time, that it will also initiate a new round of quantitative easing, initially at a low value with the amount being data dependent with respect to actual economic conditions within the U.S. economy, with the stated goal of achieving a nominal GDP growth rate target it believes it can attain by the second quarter of 2016.
At first, this seemed a little frivolous, but the more I thought about it, the more this started making sense to me.  This fits well with my conception of our current economy that is bifurcated between (1) an industrial expansion which is happening, more or less, at terminal velocity, which would probably normally be associated with short term interest rates at least in the 2% to 3% range and (2) a real estate economy which is held back by regulatory barriers to building and to credit access.

Real housing consumption is, therefore stagnant, and the relatively low elasticity of housing demand leads some of the real growth in the industrial economy to bleed into real estate.  Limits to real housing expansion mean that this increase in housing demand mostly becomes rent inflation.

So, I have, tentatively, held the opinion that early rate hikes may not be that important, because housing isn't constrained by rate spreads and the industrial economy can withstand some rate increases.  Recent market reactions suggest that I might have been too optimistic about that.

In any case, it seems to me that we have come to a new consensus that debt-financed housing is in disfavor.  All things considered, housing wouldn't have to be financed through highly leveraged bank loans.  There are numerous ways that we could conceive of a functional housing system, and some would probably operate more smoothly.  But, the problem is that since there is a focus on the misguided idea that the main problem was high home prices, unmoored by fundamental values, there tends to be a satisfaction with prices that remain low.  This satisfaction requires a willful disregard for the alarmingly low rate of new homebuilding and high rate of rent inflation, and a disregard for the unprecedented level of excess returns available to home owners at current price levels.  So, we have completely undermined our previous system of home ownership (in that expected returns cannot fall to non-arbitrage levels) and there is no consensus demand to replace it with a functional system.

Where this is leading is to a pre-HUD context, with very low homeownership rates and high equity levels (low leverage) for homeowners.  If this is the context we are determined to create, then we need to provide enough liquidity in the market to fund cash ownership.  And, as long as we withhold that liquidity, homebuilding will remain very low, rent inflation will remain high, and real estate owners will capture excess gains.

When we did have this sort of context before 1960, the banks held a large amount of securities in bank credit (treasuries, etc.).  I am no banking history expert, but I suspect that part of what was happening was that there was more demand for insured bank deposits than there was supply of bank assets with credit risk, so banks met some of the demand for deposits by holding treasuries.  (Please, correct me in the comments if I am wrong.)  Maybe today low risk non-bank savings vehicles would fill some of this demand.  Or, maybe even those avenues create some level of bank deposits.  Again, educate me in the comments if you can.
Note: the x-axis begins in 1973 on this graph.

The last piece of the puzzle here is that with our new policy of paying interest on reserves, reserves are basically a substitute for short term treasuries.  Benjamin Cole, blogger and occasional IW commenter, favors a sort of permanent QE.  And, thinking about it in terms of bank balance sheets, I think he has a point.  This is probably inevitable.

Now, I'm not sure what factors have led banks' overweight low-risk holdings to be in reserves today vs. securities back then.  Is it because of the peculiar path of monetary policy an interest on reserves beginning in 2008?  What if there was a way for the Fed to swap reserves for treasuries with the banks without creating deflationary side effects?  In any case, it seems as though the large Fed balance sheet is only different from the pre-1960 context semantically.

And, if that is the case, then it does seem like there are two tiers to future monetary policy, if we are going to retain interest on reserves.  First, is management of credit through the level of interest on reserves, and second is management of the level of bank deposits through open market operations.  To this end, a rise in interest on reserves coupled with large scale purchases of treasuries makes sense.  Treasury purchases would allow deposits to rise, even as banks were using deposits to purchase low risk securities in the form of excess reserves.  Presumably some of the cash from the open market purchases would make it into real estate markets, allowing real estate values to rise to non-arbitrage prices without the use of destabilizing debt.

This is all academic, really, because the same errors that have led to a consensus against mortgage growth would lead to curtailment of asset purchases if returns to home owners ever reaches a reasonable level, and, further, most of the potential benefits from injecting liquidity in the housing sector would depend on removing the fetters from urban residential building markets.

The public wants to spend about 18% of personal expenditures on housing, but we have a number of policies that divert those expenditures to real estate owners instead of to developers and builders, then when the inevitable pressures to rent inflation and real estate values build, we complain of stagnation and the "bubble economy".  But, instead of prescribing supply, we prescribe demand destruction.  Nothing besides real expansion of housing (mostly through the unleashing of location) will solve the stagnation problem, and I don't see any immediate possibility of remedying that problem.

But, in the meantime, Benjamin's and Ironman's QE4+ would be one way of allowing real estate prices to reach a reasonable level.  We would know when we had gone too far because inflation would begin to rise.  If real estate prices rise in a low leverage environment and we don't see consumption inflation, then who is to complain?  In fact, to the extent that new housing stock is encouraged, QE4+ would be deflationary.  Most of our current inflation is due to rent inflation because of the housing shortage.  If your complaint about the regime that I just described is that only high net worth households would be able to own homes, then I will suggest that you're arguing for a return of widespread mortgage financing.  If we pick neither, then we are picking a regime that not only locks to net worth households out of ownership, but also keeps their rents high in order to fund the excess returns of their landlords.  Of the three options, our current regime is the worst.  I'm afraid that the other two regimes require supporters who are willing to accept market prices, which is a sadly unpopulated cadre these days.


  1. You can remove the parentheses from around the word (at) in the passage of ours that you've quoted - we've corrected the grammar in the original!