Donald L Kohn: The strength in consumer durables and housing: policy
stabilization or problem in the making?
Speech by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve System,
at the Conference on Finance and Macroeconomics sponsored by the Federal Reserve Bank of San
Francisco and Stanford Institute for Economic Policy Research, San Francisco, 28 February 2003.
* * *
We have spent the day examining the intersection of finance and macroeconomics from a theoretical
and longer-run empirical perspective. I thought it might be interesting as after-dinner entertainment to
bring the topic to the here and now - to the current economic and monetary policy situation. In
particular, a number of commentators have raised the specter that imbalances are being created in the
markets for consumer durable goods and houses - unsustainably high prices or activity - that will
produce macroeconomic strains when, inevitably, they correct. These concerns obviously echo those
expressed by some observers that monetary policy allowed run-ups in equity prices and capital
spending in the 1990s that ultimately proved to be destabilizing. In that context, I thought it might be
useful to consider the choices and information available to the central bank on this related question
now - in real time - without the aid of 20-20 hindsight. I want to emphasize that what follows is focused
on the question of imbalances in houses and durables and is not intended to be a comprehensive
discussion of the outlook for the U.S. economy, which will depend on a wide array of influences I am
not addressing. I should note the views on this question are my own and do not necessarily represent
those of my colleagues on the Federal Open Market Committee.1
Monetary Policy Backdrop
The basic story is straightforward: In response to a series of developments that curtailed aggregate
demand in the United States, the Federal Reserve has eased policy aggressively, cutting the federal
funds rate 5-1/4 percentage points in two years, bringing the real federal funds rate to below zero. The
most important contributors to economic weakness have been sharp contractions in investment
spending and equity prices as businesses and investors re-evaluated the profitability of capital
spending and the productive capacity built up in the late 1990s. The lower interest rates boosted
investment in housing and consumer durables, helping to offset the drag of the decline in business
investment and the damping effects of the drop in household wealth on consumer spending. These
policy actions have kept the economy from softening even further and inflation from dropping by more
from already low levels.
To a considerable extent, monetary policy easing is working no differently today than in the past: It
stimulates interest-sensitive spending. But there are many forces at work in this cycle that have
required interest rates working through their effects on household spending to shoulder an unusually
heavy burden to support growth. Unlike most other cycles in recent U.S. economic experience, the
weakness was initiated by a cutback in investment spending. This contrast is illustrated in chart1
which shows spending relative to GDP for a number of components of investment. While business
fixed investment, shown in the upper panel, typically drops more than GDP when the economy
weakens, the recent episode is remarkable in a couple of ways. First, the drop in the high-tech share,
the red line, is unprecedented. Second, the drop in the share for non-high-tech equipment, the black
line, has been unusually steep, exceeded only in the 1979-82 episode, when the contraction in output
was far deeper.
Another unusual aspect of the current cycle is that equity prices and wealth continued to move lower
long after interest rates started falling and kept declining well after the economy seemed to have
bottomed out. This pattern appears to have occurred because the re-evaluation of corporate
profitability has persisted for some time; because of last summer's revelations of corporate misdeeds;
and because the recent increase in perceptions of geopolitical risk. These same concerns have
continued to raise risk spreads in credit markets, damping the passthrough of lower policy interest
rates to the cost of business credit. With uncertainty high and financial markets skittish, firms have
remained hesitant to commit their cash and investment has been very slow to turn around.
In addition, economic weakness and sharp declines in equity prices have been widespread globally,
and, until recently, these developments have helped keep the dollar strong despite the reduction in
interest rates. Sluggish growth in the economies of our trading partners and the relatively high dollar
have held down net exports, blunting another potential channel for monetary policy easing to bolster
spending. In the late 1990s, the rise in the dollar reflected global perceptions of expanding investment
opportunities in the United States and the resulting current account deficit provided a safety valve
through which strong domestic demand was met in part by higher foreign production. But even though
we do not need that safety valve anymore, the current account deficit has continued to increase of
late, requiring easier monetary policy to keep domestic demand elevated relative to domestic income.
In the lower panel, chart 1 also gives some sense of the extent to which household investment has
been carrying the economy. Economic contractions have frequently been led by weakness in the
household sector, which often has responded to higher interest rates as the Federal Reserve acts to
reverse inflation pressures. This pattern can be seen in the chart, where the spending shares of
housing and consumer durables typically drop sharply before and during recessions. In this episode,
however, these shares have continued to move slightly higher, despite a pronounced drop in wealth
and a weak economy. Thus, household investment has stayed unusually strong throughout the
recession and early in the recovery, buoyed, no doubt, by low interest rates.
Going Forward: The Benign Scenario
As a consequence, it is to be expected that stocks of interest-sensitive investment goods - in the
present circumstances, especially cars and houses - are greater than they would otherwise be. And
with demand for housing strong, it is perhaps not surprising that house prices are probably higher than
they otherwise would be.
But judging from the steep upward slope of the yield curve, few see interest rates as holding at current
levels indefinitely. When, at some point, interest rates rise to more typical levels, desired stocks of
these goods likely would fall, holding other factors equal, restraining this interest-sensitive spending.
But it is important to remember that such an increase in interest rates would not occur in a vacuum; it
would occur because the economy looked to be growing more vigorously. Most economists expect
that a more pronounced step-up in the pace of activity will be brought about by a recovery in business
investment from its current subdued levels. In that case, the need for high levels of spending on
housing will be reduced. And higher interest rates will be instrumental in bringing about the adjustment
in housing expenditures required to keep economic activity from overshooting its potential. In principle,
a housing or durables boom induced by monetary policy need not entail a bust that would be painful to
the economy.
Of course, it is not likely to occur as smoothly as that. Among other things, markets could get it wrong -
for example, they could anticipate greater strength in underlying demand than is actually occurring.
Then, higher interest rates would tend to damp spending unduly. But there is an "automatic stabilizer"
aspect to the interaction of financial markets and the economy. As investors realized their error, rates
would fall back. And markets would likely get a nudge from the Federal Reserve: We would set rates
lower than the markets have built in, and in our various statements we would attempt to make clear
our assessment of economic prospects. Interest rates could then stay low for an extended period, the
desired stock of housing would remain elevated, and housing investment would remain high as well.
But that would be just what is required. Alternatively, business investment could snap back faster than
expected. In that case, interest rates would rise more rapidly as the extent of the strength of demand
became clear - with, undoubtedly, some help from the Federal Reserve - weakening household
investment more sharply as would be required. With production currently well below potential and
inflation and inflation expectations low, it is doubtful that the temporary misalignment of rates would
result in the development of any perceptible inflation pressures before the Federal Reserve would
have time to take countervailing steps.
Costs and Risks to the Benign Scenario
So far I have painted a rather sanguine picture of the longer-term consequences of a
monetary-policy-induced boom in household investment. While this story has the virtues of plausibility
and internal consistency, it does involve some features that bear further thought. First, the benign
scenario relies on the transfer of productive resources across sectors - in particular, it involves
primarily the inflow of resources into the residential construction sector. Presumably, the transfer of
these resources entails some costs - retraining and perhaps relocation of workers, a different mix of
capital, and so forth. If residential construction were eventually to shrink as interest rates rose, further
costs would be incurred as those resources shifted yet again to different uses.
Another possibility is that the reality of the housing and consumer durables booms may not work out
as neatly as the benign scenario would suggest. Indeed, some have drawn the comparison with the
high-tech investment boom that peaked in 2000. As events have unfolded, it appears that firms
concluded that the investment they undertook in those years was not justified; the subsequent drop in
investment suggests that, in hindsight, firms concluded that they had "overinvested" in high-tech
equipment; and that sharp cutback in investment created a recession. Is it possible, these
commentators have asked, that the current boom in housing and durables will leave us with similar
regrets in a few years?
Furthermore, prices of houses have been rising faster than inflation in recent years, reminiscent of the
surge in equity prices through 2000. Some analysts argue that loose monetary policy is feeding a
bubble in housing prices that will eventually burst.2
In short, the question is whether the stimulus to household investment, while cushioning the economic
cycle in the near-term, is setting the stage for greater instability in the longer run.
Taking these concerns in turn:
Reallocation costs. There is little doubt that it is costly to build up a commercial enterprise. Workers
must be hired, office space rented, equipment purchased, management expertise redirected. All of
these actions entail costs. At the same time, as I already noted, if the yield curve is any indication,
interest rates will one day go back up, giving rise to the possibility that some of the current expansion
of construction firms will eventually need to be unwound.
So relying on the housing sector to offset weakness elsewhere in the economy clearly entails costs.
But these costs need to be put against the costs of underutilized resources. Facilitating an increase in
residential construction puts resources to use that would otherwise lie idle. Implicit in the conventional
story is the assumption that the costs of unemployment are significantly greater than the costs of
shifting resources across sectors; if so, the presence of adjustment costs should not seriously impede
the desire to offset weakness in spending elsewhere with greater spending on household investment.
Alternatively, a judgment that the adjustment costs were large, or the shock to demand temporary,
might argue in the direction of a more measured policy response.
While it is hard to know for sure how important these adjustment costs may be, it is worth noting that,
historically, there has been considerable variation in employment and production in the residential
construction sector. Seasonal fluctuations in residential construction are quite large, and in business
cycles from the early 1970s to the early 1990s, it was not uncommon for housing starts to drop by
more than half. So it appears that this sector of the economy has evolved in such a way that it can
expand and contract rapidly. Moreover, in the current episode, the falloff in commercial construction
has freed many resources that can readily be put to work building houses for now, then shifted back
when business spending picks up.
Similarly, even with the strong sales of light motor vehicles and other consumer durables last year,
capacity utilization in these industries for the most part has remained at moderate levels, which
suggests that the additional production induced by the monetary stimulus has occurred without
important and costly new investment in production capacity.3
In sum, it does not seem that the costs of shifting resources across sectors should be a concern now.
This is especially true when you consider that these resources would quite possibly otherwise be idle.
That is not to say that such costs might not loom larger in other circumstances - say when resources
are being temporarily shifted between the tradeable goods and nontradeable service sectors - though
policymakers and their critics would still also need to be mindful of the costs of keeping more people
unemployed.
Excesses. Perhaps the more challenging question is whether excesses and imbalances have built up
that could create economic instability in the future when they are unwound. It is not hard to see why
the issue arises. Chart 2 shows that real house prices have risen rapidly in the last few years. On a
constant quality basis, new house prices still have not breached the peak of the late 1970s, but the
prices of existing homes have sky-rocketed. Moreover, as can be seen in chart 3, the stock of
consumer durables has risen at an elevated rate in the last few years; while the stock of houses has
been growing more moderately, that pace has been maintained for some years.
The difficulties of real-time identification of imbalances are hard to overstate. One can never be sure
until well after the event whether prices or quantities have indeed deviated from sustainable levels,
because the sustainable level is never observable but must be estimated, and those estimates are
quite sensitive to the assumptions being made. This point is especially true of asset prices: For
example, the literature on both equity prices and exchange rates indicates that it is hard to beat a
random walk. A similar point can be made about investment and the capital stock - including the stock
of houses and durables. As the recent experience with business capital so graphically illustrates,
excesses are only clearly evident after the fact - and the size of the over-investment may be disputable
even then.
All that said, we can identify a number of factors that should affect what I will call the "sustainable"
stock of housing and consumer durable goods - the level that would be desired over time at particular
levels of interest rates and other key determinants of demand. Among these determinants are wealth,
permanent income, and the user cost of owning the good - in effect its "price." That price, in turn,
depends importantly on the rate of interest. The demand for housing as an asset may also reflect
some specific institutional changes. In particular, in recent decades, the rise of home equity lines of
credit and the lower costs of mortgage refinancing has meant that housing wealth has become
increasingly "liquid," and as a consequence, may have become more attractive.
Chart 4 compares the actual levels of the stocks of housing and consumer durables with their desired
levels derived from the Board staff's "FRB/US" model of the U.S. economy, using both current interest
rates and their historical averages. Somewhat surprisingly, estimates from this conventional approach
suggest that, at current interest rates, the existing stocks of houses and consumer durables are
appreciably below the sustainable levels. In this model, low interest rates have a powerful effect on the
desired stocks of housing and durables. Even when we estimate sustainable levels based on historical
average interest rates, we conclude by this method that current housing and durables stocks are about
in line with long-run demand.4 We need to keep in mind that these are only very rough estimates of
unobservable variables. But such as they are, they do not suggest that as interest rates rise we will
find that we are left with a vast oversupply of houses and durables.
What about house prices? Unfortunately, as I already noted, asset prices are even harder to model
than investment. Just as equity prices can be thought of as being the present discounted value of
future benefits of equity ownership - in principle, dividends and share repurchases - so house prices
can be thought of as being the present discounted value of the future benefits of home-ownership,
which, in theory, should be the potential market value of the rent from the house. And, just as the rate
of return on equity should fall along with interest rates, so should the rental rate of return on houses.
With rents changing very slowly over time, we ought to expect that, other things being equal, lower
interest rates would raise house prices. In addition, households may be weighing houses against
alternative investments other than bonds. In that regard, the collapse of expectations for gains from
holding equity have undoubtedly made real estate relatively more attractive, contributing to price
increases and higher activity.
On the supply side of the market, the scarcity of desirable land relative to population growth naturally
puts upward pressures on prices. In addition, productivity in construction has lagged gains in the
overall productivity of nonfarm businesses. Consequently, it should not be surprising to see the price
of housing rise relative to the prices of other goods and services.
The combination of demand and supply factors has caused house price gains to outstrip per capita
income gains in recent years. The top of chart 5 shows that the ratio of house prices to per capita
disposable income has increased substantially since 1998. But owing to the decline in mortgage rates,
this has not made housing less affordable. The bottom of chart 5 shows an index of housing
"affordability," which compares the mortgage payment on a typical home to median household income;
high levels of the index mean greater affordability. Although house prices outpaced income through
much of the late 1990s, housing remained quite affordable by historical standards. It does not appear
that the rise in prices has meant that the market is being supported on an increasingly narrow base,
given increases in incomes and declines in interest rates. If interest rates were to rise so that real
mortgage rates were equal to their long-term average, the affordability index would drop back, but only
to a level that would still leave houses more affordable than they were in the second half of the 1980s.
Conclusion: Implications and Policy Choices
In sum, the rise in housing prices and the increase in household investment in houses and consumer
durables do not appear out of line with what might be expected in the current environment of low
interest rates and continuing growth in real disposable incomes. Judging from this analysis, and
bearing in mind its inherently tentative - if not speculative - character, it seems likely that as the
economy strengthens and interest rates rise in response, household investment and prices are likely
to soften some relative to recent trends, but not to break precipitously. Houses and cars would not be
providing the impetus to economic activity they often have in past recoveries, but they do not appear
set to replicate the experience of fiber-optic cable.
We are making inferences from very inexact proxies for desired stocks and sustainable prices. No one
could definitively rule out the possibility that home construction and prices could drop sharply.
Undoubtedly this will occur in some local markets, and it could become widespread. But the odds
would seem to favor a more measured response to the inevitable tightening of policy as the recovery
in business investment picks up steam, consistent with keeping the economy on a sustainable growth
track rather than becoming another source of macroeconomic instability.
And weighing those odds is what policy is all about: Making choices in real time, using incomplete
knowledge of future asset market behavior, and weighing potential costs and benefits for economic
performance over time from alternative policy strategies.
By lowering interest rates aggressively, the Federal Reserve undoubtedly has shifted some forms of
economic activity from the future to the present. In effect, we are trying to cushion the effects of
decisions by the private sector to postpone business capital spending for now. Adjustment costs aside,
and these appear to be minor, it is not clear why we would not want to bring construction spending in
from the future, when it is likely that other parts of the economy would not be so weak. It makes sense
to build the houses and cars now, when the cost of doing so is relatively low, rather than waiting. And
building them now has kept more people employed and reduced the risk of deflation. All in all, from my
perspective, with the knowledge and analysis available to me, the policy choices we have made seem
consistent with fostering our legislated goals of maximum employment, stable prices, and moderate
long-run interest rates, not only in the near term, but most likely over the longer run as well.
BIS Review 11/2003
BIS Review 11/2003
BIS Review 11/2003
BIS Review 11/2003
BIS Review 11/2003