Adrian W. Throop

English

Research Papers in Economics

FRBSF WEEKLY LETTER
October 31, 1986
Slight Moderation in the Housing Cycle
Investment in housing has exhibited large fluc-
tuatioo? jnth~PQ5twilr PeriQO,lnoOe view,
financial regulation is the prirne culprit, reduc-
ing the availability of credit for housing by con-
centrating the effects of tight credit conditions
on that sector. Another view blames the high
interest-sensitivity of demand for housing,
This Letter looks at the extent to which the avail-
ability of credit for housing investment has
affected that investment. We focus on the extent
to which interest rate ceilings and other financial
regulations created outflows of deposits at thrift
institutions and consequent "credit availability"
effects that reduced residential investment dur-
ing periods of tight credit. Thrifts supply nearly
half of the total credit needs of housing.
Our basic finding is that the effects of credit
availability on residential investment were rela-
tively small even prior to the financial deregula-
tion that began in the late 1970s. Also, although
financial deregulation appears to have elimi-
nated specific credit availability effects on resi-
dential investment, the extent to which
fluctuations in the overall housing cycle have
been dampened is relatively small.
Deregulation and credit availability
Thrift institutions have experienced recurrent
bouts of deposit outflows (disintermediation) in
periods of high interest rates both before and
after financial deregulation. The earlier periods
of disintermediation appeared related mainly to
the effects of Regulation Q, which set limits on
the interest rates paid on deposits by thrifts that
specialized in housing finance.
When interest rates were high, ceilings on
deposit rates tended to restrict deposit flows into
thrift institutions. The flow of credit to housing
would not have been reduced if thrifts had been
able to sell assets or borrow from government
agencies or other lenders to obtain alternative
sources of housing finance. But two factors in
addition to Regulation Q ceilings helped con-
centrate the effect of tight credit conditions on
housing: 1) a limited secondary market for mort-
gage loans, and 2) usury ceilings on mortgage
loans. To the extent that a limited secondary
market did not allow thrift institutions to offset
the lackofdeposit flows by selling mortgages
from their portfolios, and usury ceilings pre-
vented other lenders from filling the void, tight
credit conditions affected housing more heavily
than other investments.
Restrictions on housing finance were either
eliminated or substantially relaxed inthe 1970s.
A significant secondary mortgage market
developed during the decade, and by the late
1970s and early 1980s, most ceilings on deposit
rates and usury ceilings on mortgage rates had
been removed. A major early element of
deregulation affecting housing was the relaxa-
tion of Regulation Q ceilings in June 1978,
which allowed both thrifts and commercial
banks to issue Money Market Certificates with
an interest rate tied to 6-month Treasury bills.
Subsequently, the Deregulation and Monetary
Control Act of 1980 authorized the phase-out
and ultimate removal of all limitations on inter-
est and dividends paid on deposits and accounts
at depository institutions. The phase-out period
lasted until April 1986, but substantial deregula-
tion took place almost immediately. The
Deregulation and Monetary Control Act also
eliminated most state usury ceilings on residen-
tial mortgage loans and broadened the asset
powers ofthrift institutions.
Interest-sensitivity
The various elements of financial deregulation
should have allowed housing to compete against
other investments offunds on a more nearly
equal basis and thereby dampened fluctuations
in housing construction. But sharp cycles in the
flow of real, or inflation-adjusted, deposits to
thrifts have by no means been eliminated, as
shown in Chart 1.
Because residential investment is highly sensi-
tive to interest rates, strong cycles in deposit
flows at thrifts could still occur even in relatively
unregulated markets. Simply put, thrifts' need for
deposits varies with the amount of mortgage
loans demanded. Thus, deposit flows into thrifts
would tend to follow a cyclical pattern in
response to interest rate variations regardless ofFRBSF
regulations. For example, even after the intro-
ductiOn Of MOney MarkeFCertific:ates·in]une
1978, the total flow of real deposits into thrifts
continued to fluctuate sharply and inversely with
the overall level of interest rates. Deposit flows
out of thrifts still occur in a relatively unregu-
lated financial environment when the demand
for mortgage finance is curtailed by high levels
of mortgage rates, which reduces the amount of
funds that thrifts are willing to raise in deposit
markets.
Simulated effects
To isolate the effect of disintermediation on resi-
dential investment due to regulatory constraints,
we used an econometric model. In this model,
the demand for housing depends upon perma-
nent disposable income and the "user cost" of
capital in housing. The user cost of capital is
simplythe effective per period payment for capi-
tal and depends on market interest rates, taxes,
and the physical rate of depreciation. In the
model, the demand for housing in combination
with the current stock of housing determines the
relative price of housing. The amount of residen-
tial investment then responds to the profitability
of construction as affected by its relative price.
Depositflows in periods of severe disintermedia-
tion were put into the model to account for pos-
sible credit availability effects on residential
investment due to financial regulation. The
deposit flow variableshad statistically significant
depressing effects onresidential investment in
the 1966-67, 1969-70 and 1974-75 periods of
severe disintermediation, but noUn the 1979-81
period after a significant degree of deregulation
had occurred. Also, deposit flows did nothave
any significant effects in other periods.
The above results suggest that financial regula-
tion did exacerbate swings in the housing cycle
to a measurable degree prior to 1979. But the
magnitude of this effect depends not only on the
direct effect on housing starts caused by disinter-
mediation at thrifts, but also on indirect effects
operating through market interest rates. Effec-
tively binding Regulation Q ceilings on deposit
rates tended to moderate increases in market
interest rates during periods oftight credit by
reducing the extent of price competition for
credit.
Similarly, financial deregulation tends to
increase the degree to which market interest
rates rise in periods of tight credit because the
supply of credit is rationed to a greater extent by
price. Thus, although deregulation tends to
reduce fluctuations in residential investment by
eliminating direct credit availability effects, it
also works to increase housing fluctuations
somewhat by creating more volatile market
interest rates.
Therefore, we estimated the full effect of finan-
cial deregulation on the housing cycle by
embedding the above model of residential
investment into a larger structural mac-
roeconomic model. The degree to which finan-
cial deregulation has lessened the severity of the
housing cycle was simulated by removing the
estimated effect of deposit flows on housing
activity in the 1966-67,1969-70, and 1974-75
periods whentheywere found to have a
depressing effect, assuming no change in mone-
tary growth.
In other words, we eliminated the credit avail-
ability effects directed specifically at housing.
The result was a reduction in the cyclical vari-
ability of residential investment when account
was taken of both direct effects operating
through deposit flows and indirect effects work-
ing through market interest rates.
The historical behavior of residential investment
and the simulation of what itwould have been
in the absence of any constraining financial reg-Chart.1
Real Deposits at Thrift Institutions
Percent*
20
16
12
8
4
OI----tJ---=-+-+--~I-/---P"rl_f--
-4
1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984
* Quarterly percent change at annual rates
Chart 2
Real Residential Investment
Silllons of
1972 dollars
69
66
63
60
57
54
51
48
45
42
39
36
33
1964 1966 1968 1970 1972 1974 1976 1978 1980 19821984
Shaded areas represent periods of estimated credit availability effects.
ulation are both shown in Chart 2. In the
absence of credit availability effects due to
financial regulation, the simulation shows that
residential investment would have been up to 12
percent greater in some months during the three
periods of severe disintermediation in 1966-67,
1969-70, and 1974-75.
However, because of the high sensitivity of the
demand for housing to interest rates plus the fact
that Regulation Q ceilings were not binding all
of the time, the overall reduction in the cyclical
variability of residential investment is estimated
to be quite small. A quantitative measure of
cyclical variability is the percentage standard
deviation of a variable from its trend. The lower
this standard deviation, the less the variability.
For the 1966-75 period, the standard deviation
of residential investment from its trend is
reduced from 18.9 percent in the actual histor-
ical data to only 18.3 percent in the simulated
absence of credit availability effects ~ a decline
in overall variability of only 3.2 percent.
Conclusion
The results of our study of swings in residential
investment indicate that, even before financial
deregulation, the major reason for large fluctua-
tions was the relatively high sensitivity of hous-
ing demand to interest rates, and not credit
availability effects caused by interest rate ceil-
ings and other financial regulation. Another find-
ing is that financial deregulation did eliminate a
small but identifiable credit availability effect on
residential investment during periods of high
interest rates. We therefore conclude that finan-
cial deregulation has moderated swings in the
housing cycle to only a minor degree.
Adrianw. Throop
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthemanagementofthe Federal Reserve Bank of San
Francisco, orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong)ortothealJthor...•FreecopiesofFederal Reservepublications
can beobtained from the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6U!ljsom ljo~n U060JO 0POl\0U
oljoPI !!omoH O!UJoJ!l0) ouozPl::J o~soll::J
O)SI)UOJj UOS
JO ~U08
aAJaSa~ IOJapaj
~uew~Jodea lpJOeSe~
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
10/8/86
Change
from
10/1/86
Change from 10/9/85
Dollar PercenF
Loans, Leases and Investments1 2 201,823 -1,359 4,546 2.3
Loans and Leases1 6 181,125 -1,260 3,006 1.6
Commercial and Industrial 49,752 - 97 - 1,475 - 2.8
Real estate 66,602 - 44 1,250 1.9
Loans to Individuals 39,545 - 117 1,740 4.6
Leases 5,616 5 215 3.9
U.S. Treasury and Agency Securities2 12,573 - 3 707 5.9
OtherSecurities2 8,125 - 96 833 11.4
Total Deposits 205,847 -3,252 5,983 2.9
Demand Deposits 52,670 -3,295 5,449 11.5
Demand Deposits Adjusted3 36,481 - 263 - 7,032 -16.1
OtherTransaction Balances4 17,877 394 3,522 24.5
Total Non-Transaction Balances6 135,300 - 351 - 2,987 - 2.1
MoneyMarket Deposit
Accounts-Total 46,375 - 387 1,160 2.5
Time Deposits in Amounts of
$100,000 or more 33,581 90 - 5,061 -13.0
Other Liabilities for Borrowed MoneyS 27,404 - 556 3,092 12.7
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+}/Deficiency(-)
Borrowings
Netfree reserves (+}/Net borrowed(-)
Period ended
10/6/86
36
24
12
Period ended
9/22/86
20
27
7
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes u.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percent change

Slight moderation in the housing cycle

http://www.frbsf.org/publications/economics/letter/1986/el86-44.pdf

Slight moderation in the housing cycle

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics