Thursday, December 03, 2009

Another Fed Guilt Denial

James MacGee, research associate at the Federal Reserve Bank of Cleveland tries to deny that the Fed's monetary policy had any significant impact (though he unlike some others concede a trivial impact) on the U.S. housing bubble by comparing the U.S. housing market to the Canadian housing market, claiming that Canada did not have a bubble even though interest rates were essentially the same, something which proves that something else had to be involved.

But first of all, even initially conceding for the sake of the argument that his interpretation of the facts is correct, that does not exonerate monetary policy. If the U.S. market had a bigger responsiveness to monetary policy than the Canadian, than monetary policy is still responsible. To use an analogy, if someone ignited a fire on a pile of newspapers soaked in gasoline they would still be responsible even if similar actions with a lighter to a pile of newspapers soaked in water didn't cause a fire.

And secondly, while such a strong empirical correlation is not needed to establish a causal relationship for reasons mentioned in the previous paragraph, the fact is that there was a strong relationship between interest rate movements and house price movements. Compare these two graphs from MacGee's article (the first is the one depicting house prices, the second the one that depicts short-term rates).

As you can see, between late 2001 and mid 2004, when U.S. interest rates were below Canadian, U.S. house prices rose significantly relative Canadian. After that, when Canadian interest rates were higher, Canadian house prices rose a lot faster. So during the bubble years (though not before or after), the negative correlation between interest rates and house prices were almost perfect.

It should be noted that MacGee tries to deny this by comparing a 5-year fixed rate mortgage in Canada with a 30-year in the U.S., overlooking of course the great role of adjustable rate mortgages during the U.S. housing bubble. And as the house price graph shows, Canada did in fact have a housing bust too, though less serious than in the U.S.