The Fed Has to Distinguish Between Leaning Against Bubbles and Leaning Against Rising Housing Prices

May 23, 2018

CEPR

MarketWatch had a short piece reporting that Michael Woodford, one of the country’s most prominent macroeconomists, is now arguing that the Fed should actively look to stem the growth of asset bubbles like the housing bubble in the last decade. It points out that house prices have been rising rapidly in recent years. It also notes that Woodford argues the Fed should not distinguish between run-ups in house prices based on fundamentals and run-ups based on speculation.

As someone who advocated the Fed should counteract bubbles long before the crash of the housing bubble sank the economy, I am glad to see Woodford make this case. However, I think he is badly mistaken in arguing for using interest rate policy, rather than regulatory policy and public statements and information to try to sink a bubble. Also, it is very important to distinguish between a bubble-driven run-up in house prices and one driven by the fundamentals of the market.

Interest rates are a very inefficient tool for targeting an asset bubble. High enough interest rates will eventually burst the bubble, but they will also sink the economy. Bubbles are not likely to respond to modest increases in interest rates absent other measures from the Fed.

The effort to target rising housing prices, if they are driven by fundamentals (as is now the case), is likely to be self-defeating. Insofar as house prices are driven by fundamentals, it means that the best way to bring them down is by increasing supply. While this can be done through changing zoning policy at the local level, the Fed is not in a position to directly affect zoning. However, higher interest rates will reduce construction, making shortages of housing worse.

While higher rates will also eventually reduce demand by making house buying less affordable, this is a very indirect way of addressing the problem. It also means that it addresses a real shortage of housing by making it difficult for people to buy homes rather than increasing the supply. That doesn’t seem like good policy.