Presentation to the Fourth Annual Haas Gala
San Francisco, CA
By Janet L. Yellen, President and CEO of the Federal Reserve Bank of
For delivery October 21, 2005 8:55 PM Pacific Time, 11:55 PM Eastern
Housing Bubbles and Monetary Policy
Tonight I would like to focus on how the Fed, or central banks, more
generally, should respond to asset price bubbles. This is one of the
few policy issues where the Fed's approach has come in for real criticism.
I thought it might be of interest to this audience since, one way or
another, it has probably touched the life of almost everyone here in
the Bay Area. I saw that in memorable ways when I returned to MBA teaching
at Haas in the fall of 1999 after a stint in Washington including 2½ years
as a Governor of the Fed. During one class, I heard some background
buzz. A student in my global macroeconomics class was chattering away
on his cell phone. I looked his way and frowned. He apologized, explaining
that he was finalizing the details for his internet startup to go public.
Those were heady days in the markets, in the Bay Area, and at Haas.
The Fed suspected there was a stock price bubble developing as early
as 1996. I was still at the Board when Greenspan made his famous irrational
exuberance speech. The Fed chose not to try to burst the bubble. Instead,
it did its very best to pick up the pieces when the bubble finally
popped. I think that effort was pretty successful. But many observers
wonder if we erred and think the Fed should have tightened monetary
The question is not one of purely historic interest.
Today, it's not stock prices but house prices that have been soaring.
Those of us who
live in the Bay Area know that you can't get through a cocktail party
without some discussion of an eye-popping price somebody just got
for their two-bedroom, one-bath handyman special.
But the Bay Area isn't
the only place in the country, or the world, for that matter, where
soaring house prices have raised concerns about national economic
stability. In the U.S. as a whole, the share of residential investment in GDP
is now at its highest level in decades, and this sector has been a key source
of strength in the current expansion. The question for policy is: will this
source of strength reverse course and become instead a source of weakness?
bluntly: Is there a house-price "bubble" that might deflate, and if
so, what would that mean for the nation's economy? What, if anything, should
policy do beforehand? Fortunately, there is a large scholarly literature on asset
price bubbles and monetary policy, and Haas faculty in finance, economics and
real estate have made important contributions.
The literature generally defines
a bubble as a situation where the price of an
asset—in this case, housing—is significantly higher than its fundamental
value. One common way of judging whether housing's price is in line with its
fundamental value is to consider the ratio of housing prices to rents. This is
analogous to the ratio of prices to dividends for stocks. In the case of housing,
rents reflect the flow of benefits obtained from housing assets—either
the monetary return from rental property, or the value of living in owner-occupied
housing. Historically, the ratio for the U.S. has had many ups and downs, but
over time it has tended to return to its long-run average. In other words, when
the price-to-rent ratio is high, housing prices tend to grow more slowly or fall
for a time, and when the ratio is low, prices tend to rise more rapidly. I want
to emphasize, though, that this is a loose relationship that can be counted on
only for rough guidance rather than a precise reading.
Currently, the ratio for
the U.S. is higher than at any time since data became
available in 1970—about 38 percent above its long-run average. Of course,
the ratios vary widely from place to place in the U.S. and in different countries.
For Los Angeles and San Francisco, the price-to-rent ratio is about 75 percent
higher than the normal level, while for Cleveland the ratio is very near its
historical average. For the U.K., the ratio is more than double its long-run
average, whereas in Japan it's only about three-quarters of its normal level.
than normal ratios do not necessarily prove that there's a house-price bubble.
House prices could be high for some good, fundamental reasons. For
example, there have been changes in the tax laws that reduce the potential
tax bite from
selling one home and buying another. Another development, which may be making
housing more like an investment vehicle in the U.S., is that it's now easier
and cheaper to get at the equity—either through refinancing, which has
become a less costly process, or through an equity line of credit. These innovations
in mortgage markets make the funds invested in houses more liquid. There are
also constraints on the supply of housing in a number of markets, including
the Bay Area. Probably the most obvious candidate for a fundamental factor
mortgage interest rates. Even so, the consensus seems to be that the high price-to-rent
ratio for housing cannot be fully accounted for by these factors. So, while
I'm certainly not predicting anything about future house price movements, I
it's obvious that the housing sector represents a serious issue for monetary
policymakers to consider.
How, then, should monetary policy react to unusually
high prices of houses—or
of other assets, for that matter? As a starting point, let me note that the
issue is not now (nor during the stock market boom) whether policy should react
all. As part of its analysis of demand in the economy, central bank models
have long incorporated the wealth effect of house prices and other assets on
it is just one of many factors, including fiscal policy, exchange rates, and
so on, that affect demand. The debate lies in determining when, if ever, policy
should be focused on deflating the asset price bubble itself.
In my view, it
makes sense to organize one's thinking around three consecutive
questions—three hurdles to jump before pulling the monetary policy trigger.
First, if the bubble were to deflate on its own, would the effect on the economy
be exceedingly large? Second, is it unlikely that the Fed could mitigate the
consequences? Third, is monetary policy the best tool to use to deflate a house-price
My answers to these questions in the shortest possible form are, "no," "no," and "no." In
the most thorough possible form, my answers might take a few hours, and would
give full play to the many gray areas that are involved. Since the short answer
is not satisfactory and the thorough one overwhelms our time limits, I will compromise
and give just a brief explanation for my trio of "nos."
In answer to
the first question on the size of the effect, it could be large enough to feel
like a good-sized bump in the road, but the economy would likely
to be able to absorb the shock. For example, a reversion to the long-run price-rent
ratio would appear to represent a shock that is only about half the size of
the U.S. stock market collapse in 2000 and 2001.
In answer to the second question
on timing, the spending slowdown that would ensue is likely to kick in gradually,
because it mainly affects household wealth.
This is important, because Fed policy actions don't have instantaneous effects,
but work through the economy over time. So the impact of a gradual spending
slowdown could well be cushioned by an easier policy.
In answer to the third question
on whether monetary policy is the best tool to deflate a house-price bubble,
there are several points to consider. For one thing,
no one can predict exactly how much tightening would be needed, or by exactly
how much the bubble should be reduced. Beyond that, a tighter policy to deflate
a housing bubble could impose substantial costs on other sectors of the economy
that would lead to equally unwelcome imbalances. Finally, it's possible that
other strategies, such as tighter supervision or changes in financial regulation,
would not only be more tailored to the problem, but also less costly to the
all of these points into consideration, it seems that the arguments against
trying to deflate a bubble outweigh those in favor of it. So, my bottom
is that monetary policy should react to rising prices for houses or other assets
only insofar as they affect the central bank's goal variables—output, employment,
and inflation. But I want to stress that the debate surrounding these issues
is still very much alive. As I hinted earlier, there are significant "gray
areas" to consider, and these, of course, are often the most interesting,
because they involve both subtlety and the complex interplay of economics, politics,
and human psychology.
I hope that, in these remarks, I have given you some insight
into how at least one policymaker is framing the question of whether to respond