Housing ; Housing - Prices ; Gross domestic product

Frank Smets

English

Research Papers in Economics

235
Prof. Leamer’s paper is witty, provocative and very timely. It is also 
written with a certain passion. Now, passion and central banking do 
not necessarily go well together. Boredom is an attribute more often 
associated with central banking. So, unfortunately part of my task 
will be to try to take out some of the passion, in particular when it 
comes to drawing the implications of Prof. Leamer’s findings for the 
design of monetary policy. 
Prof. Leamer’s claim is “Housing is the business cycle.” I will basi-
cally make three main comments. First, in view of the high interest 
rate sensitivity of residential investment compared to other gross do-
mestic product (GDP) components, a crucial factor for understand-
ing the relationship between the housing cycle and the business cycle 
are interest rates. It would therefore be useful to assess whether the 
leading indicator properties of housing starts continue to hold once 
interest rates and, in particular, the term spread are taken into ac-
count. If most of the leading indicator properties of housing come 
from the interest rate cycle, then we need to think about monetary 
policy and not the housing market as a source of business cycle move-
ments. Second, the paper contains no discussion of how problems in 
the housing market may spill over to other components of GDP. 
This should be an important element of the analysis, as residential 
Commentary: Housing is 
the Business Cycle
Frank Smets236  Frank Smets
investment can not explain recessions by itself given its small share in 
GDP. I will argue that the crucial channels are likely to be financial, 
which are very much ignored or downplayed in Prof. Leamer’s paper. 
Third, Prof. Leamer argues in favour of a housing target for the Fed. 
I will argue that the evidence in his paper suggests there is no signifi-
cant trade-off between stable and low inflation and a stable housing 
market. If anything, the two are complementary. 
The main point of the paper is that most recessions in the US since 
the WWII have been preceded by a slowdown in housing or residen-
tial investment with an average cumulative negative contribution to 
GDP of about 0.6 percent the year before the peak of the cycle and a 
negative contribution of about 0.4 percent two quarters into the re-
cession. Charts 6 and 8 of the paper are quite striking in this respect. 
Given the relatively small share of residential investment in real GDP 
(on average since 1985, residential investment contributes only 4.2 
percent to overall growth in the US), this contribution is surprisingly 
large, but it is not the largest: Durables contribute almost 1.4 per-
cent, inventories almost 1.2 percent, and also equipment and soft-
ware contribute almost 1 percent. As a result, as indicated in Table 3 
of Prof. Leamer’s paper, when you are concerned with the total loss 
of GDP during recessions, residential investment is an important 
component, but it is not the only one you should worry about: On 
average it contributed about 15 percent, with inventories, consumer 
durables, equipment and software, consumer nondurables, and ex-
ports contributing about the same, given a plus/minus 4 percentage 
point confidence set. 
The point I want to make is that if we are particularly concerned 
with developments in the housing market, it is not because residen-
tial investment contributes the most to recessions. It must be for ei-
ther or both of two reasons: because residential investment is a robust 
signal for an upcoming recession and, hence, it is a useful leading 
indicator for recessions and a more general slowdown of the econo-
my, and/or because developments in residential investment have par-
ticularly strong multiplier/spillover effects on other sectors and GDP 
components. While the paper provides suggestive and reduced-form Commentary  237
evidence in Section 3 for both phenomena, these two points could 
have been elaborated a bit more. 
So, my first question is: Do housing starts continue to be a strong 
leading indicator once other factors such as the term spread are taken 
into account? My tentative answer based on the literature is prob-
ably much less than could be implied by the timing analysis of Prof. 
Leamer in Section 3. For example, Estrella and Mishkin (1999) find 
that housing starts is one of the few leading indicators that do pro-
vide additional information content for the probability of a recession 
compared to the term spread. However, while the term spread pro-
vides strong leading information four and more quarters ahead, the 
additional information provided by housing starts is limited and at 
a shorter horizon (two to three quarters). These findings are likely to 
be due to the high interest rate sensitivity of residential investment 
as also shown in Section 6 of the paper. Indeed, recent research by 
Erceg and Levin (2003) suggests that over the period 1966 till 2000, 
an unexpected change in the federal funds rate has an impact on 
residential investment that is about twice as large as on consumer 
durables, three times as large as on business equipment, four times as 
large as on business structures and 10 times as large as on other GDP 
components.1 This is important because if the reason for why resi-
dential investment is the first to go down before a recession is its high 
interest rate sensitivity compared to other components, then we need 
to think about monetary policy as a source of business cycle move-
ments, and the housing market may just be a part of the transmission 
mechanism. Below I will highlight some suggestive evidence (from 
the paper) that indeed some of the boom-bust nature of the housing 
market in the 1970s and early 1980s could be associated with un-
stable monetary policy and high and variable inflation. In contrast, 
when inflation was low and stable and monetary policy systematic 
and predictable as in the second half of the 1980s and the 1990s, also 
the boom-bust nature of the housing market was reduced. 
Second, there is very little or no analysis in the paper about why 
problems in the housing market would spill over in the other GDP 
components. The paper often gives the impression that recessions are 
all due to the residential construction sector, but that can not be true 238  Frank Smets
given its small share. Understanding the reasons behind a possible   
multiplier effect from the housing market into other GDP compo-
nents is obviously crucial in assessing the risks that the current turmoil 
leads to a recession. In this respect, Prof. Leamer appears to downplay 
the role and the importance of financial channels such as the wealth/ 
collateral effect from housing valuations. In contrast, in my view, the two 
main channels are financial. The first one is the wealth/collateral chan-
nel, which is akin to a broad balance sheet channel as it works through 
the balance sheet of the borrowers.2 The paper by John Muellbauer 
in this conference volume reviews the literature on this channel and 
finds that it is generally quite strong in countries like the United States 
and the United Kingdom with quite flexible and developed mortgage 
markets. These findings are also confirmed in research by European 
Central Bank (ECB) colleagues using cross-country evidence (e.g., 
Slacalek, 2006, and Calza, Monacelli and Stracca, 2006). The very 
interesting evidence in Section 5 of Prof. Leamer’s paper that during 
the most recent boom the appreciation of house prices was the larg-
est for cheaper properties could also be consistent with an important 
collateral channel. To the extent that poor, low-income households 
are also the households that are more likely to be credit constrained 
and that buy cheaper properties, one would indeed expect that the 
relaxation and tightening of credit constraints with rising and falling 
house prices lead to a more pronounced cycle in cheaper proper-
ties. The role of widespread negative housing equity amongst many 
households and its impact on consumption in the deep UK reces-
sion of the early 1990s is a particularly sharp historical example. The 
second channel is more akin to the traditional bank lending channel. 
It works through the balance sheet of the lenders, i.e., banks and 
other financial intermediaries. The interaction between booms and 
busts in the residential housing and associated credit market, and the 
resulting financial fragility and weak balance sheets of the financial 
sector in causing deep recessions, has been highlighted in the litera-
ture on asset price booms and busts (e.g., Borio, 2002; Detken and 
Smets, 2004; and Adalid and Detken, 2007). These episodes point 
to the possibility that initial defaults in the mortgage market may 
undermine the financial strength of the banking sector and lead to a Commentary  239
general tightening of credit standards, which may affect all domestic 
demand components that depend on external financing. 
Whether problems in the housing sector will spill over to other 
sectors will therefore very much depend on factors such as the finan-
cial position of households, the financial position of banks, and more 
generally the robustness and stability of the financial system. This is 
not the place and the time to make such an assessment, but if we take 
the experience of the last two recessions as a guide, there may be some 
reason for optimism. Table 1 of Prof. Leamer’s paper clearly confirms 
the so-called Great Moderation, i.e., the fact that the standard devia-
tion of GDP growth has fallen by more than a half since 1984-85. 
In relation to this, there are two observations that are interesting for 
our purposes. First, while the contributions of all GDP components 
in Table 1 show a fall in volatility, it is interesting to note that the 
largest relative drop is in residential investment.3  As a result, the vola-
tility of the contribution of residential investment to GDP growth 
is one of the lowest in the 1985-2006 period and similar to that of 
nondurables. Only the contributions of government spending and 
structures show a smaller volatility. Secondly, a less known fact, which 
was recently highlighted by Mojon (2007), is that one of the biggest 
contributions to the overall fall in the variability of GDP growth since 
1984 is the fall in the covariance of consumer investment (which   
includes residential investment and durables) with other components 
of GDP such as nondurable consumption or corporate investment.4 
This correlation dropped from 0.63 in the earlier period to 0.20 in 
the 1984-2005 period. What can explain this? Mojon (2007) shows 
that monetary policy itself may be an important factor. In the earlier 
period of the great inflation, instability in monetary policy as captured 
by a large variance of unsystematic monetary policy changes contrib-
uted to a larger correlation between consumer investment and other 
components in demand. To the extent that inflation is much more 
stable and monetary policy more systematic in the second period, 
the correlation could be expected to stay low. Second, several authors 
(e.g., Campbell and Hercowitz, 2004; Dynan et al., 2006; and oth-
ers) have argued that with financial deepening, consumer and invest-
ment spending can decouple from the housing cycle. Both arguments 240  Frank Smets
should be relevant for assessing whether the current turmoil in the 
housing market is likely to spill over in a more general slowdown. 
Finally, let me comment on some of the implications and lessons 
Prof. Leamer draws for the design of monetary policy. He argues that 
the importance of the housing cycle in recessions and “the differ-
ences in the dynamics of inflation and housing create a problem for 
the conduct of monetary policy that is aimed at both inflation and 
housing-related employment.” Here I am much less convinced by the 
arguments and the analysis. One of the things we have learned from 
Bob Lucas is that we should not take reduced-form relationships as 
structural when performing policy analysis. There is a large literature 
that shows that as central banks around the world have managed to 
stabilise inflation and maintain price stability, the persistence of infla-
tion has dropped (e.g., Benati, 2007) or, alternatively, the persistent 
component has become much less important and almost negligible 
(e.g., Stock and Watson, 2007). The reason is clear: The combina-
tion of the improvement of the institutional framework (with central 
bank independence, accountability for a well-specified goal of price 
stability and transparency) and the actual performance of low and 
stable inflation has contributed to an anchoring of inflation expecta-
tions to the inflation objective. As a result, shocks to inflation are no 
longer as persistent as they used to be. A similar reasoning can be fol-
lowed for the boom-bust nature of the housing market. When infla-
tion is high and variable, interest rates including bond and mortgage 
yields will be high and variable and contribute to a variable housing 
market. In contrast, if the central bank focuses on keeping inflation 
in check, bond and mortgage yields will be much more stable as 
inflation expectations are well anchored, and this will contribute to 
a stable housing market. The evidence presented in Prof. Leamer’s 
paper points in this direction. I have already referred to the fact that 
the variability of the contribution of residential investment has fallen 
as inflation has come down in the most recent period. Prof. Leamer’s 
own report card for the Fed also points in that direction. When in-
flation was high and variable, also called the great inflation period 
(1966-1982), the central bank got mostly F’s and an occasional D. 
When inflation was brought down and stable, the central bank got Commentary  241
a B+ and an A-. Indeed, Chart 30 clearly shows that the boom-bust 
behaviour of housing starts was highest during the great inflation 
period. The F for the last cycle is a matter of debate, as the boom 
in house prices may also be related to other, non-monetary policy 
factors such as the savings glut and its impact on lower worldwide 
long-term interest rates. So, my take on this is that there is no serious 
conflict between inflation stabilisation and stabilising the housing 
market. Low and stable inflation will contribute to low and stable 
nominal and real mortgage interest rates, which will in turn lead 
to a stable housing market. The two objectives are complementary, 
and there is no need to have a specific target for the housing market. 
In fact, this would be counterproductive if it leads to situations in 
which shocks originating from the housing market would undermine 
the central bank’s credibility and reputation to maintain price stabil-
ity. It also has the risk of interfering with a proper risk assessment by 
borrowers and lenders in the mortgage market.       
Author’s Note: The views expressed are my own and do not necessarily reflect those 
of the European Central Bank.242  Frank Smets
Endnotes
1As argued in Dynan et al. (2006), the interest rate sensitivity may have fallen some-
what in the most recent period due to the deregulation of the mortgage market. 
2See Bernanke and Gertler (1995).
3A recent study by Fed economists Dynan, Elmendorf and Sichel (2006) shows 
that residential investment has become much less sensitive to changes in interest 
rates (including mortage rates) since the early 1980s.
4See Benoit Mojon (2007).Commentary  243
References
R. Adalid and C. Detken (2007), “Liquidity shocks and asset price boom/bust 
cycles,” ECB Working Paper 732, February 2007.
L. Benati (2007), “Investigating inflation persistence across monetary regimes,” 
ECB Working Paper, forthcoming. 
B. Bernanke and M. Gertler (1995), “Inside the black box: The credit channel of 
monetary policy transmission,” Journal of Economic Perspectives, Winter 1995.
C. Borio and P. Lowe (2002), “Asset prices, financial and monetary stability: 
Exploring the nexus,” BIS Working Paper 127.
J. Campbell and Z. Hercowitz (2004), “The role of housholds’ collateralized debts 
in macroeconomic stabilisation,” American Economic Review.
A. Calza, T. Monacelli and L. Stracca (2007), “Mortgage markets, collateral 
constraints and monetary policy: Do institucional factors matter?” mimeo, 
European Central Bank.
C. Detken and F. Smets (2004), “Asset price booms and monetary policy,” in Siebert, 
H. (2004) (ed.), Macroeconomic Policy in the World Economy, Springer: Berlin.
K. Dynan, D. Elmendorf and D. Sichel (2006), “Can financial innovation help to 
explain the reduced volatility of economic activity?” Journal of Monetary Economics 
53(2006), 123-150.
C. Erceg and A. Levin (2003), “Optimal monetary policy with durable and non-
durable goods,” Federal Reserve Board, April 2003.
A. Estrella and F. Mishkin (1999), “Predicting US recessions: Financial variables as 
leading indicators,” The Review of Economics and Statistics, 45-61.
B. Mojon (2007), “Monetary policy, output composition and the Great Moderation,” 
Federal Reserve Bank of Chicago WP 2007-07.
J. Stock and M. Watson (2007), “Has inflation become harder to forecast?” Journal 
of Money, Credit and Banking, 39, 3-34.
J. Slacalek (2006), “What drives personal consumption? The role of housing and 
financial wealth,” mimeo, November 2006.

Asset price booms and monetary policy,”

Asset prices, financial and monetary stability: Exploring the nexus,” BIS Working Paper 127.

Can financial innovation help to explain the reduced volatility of economic activity?”

Has inflation become harder to forecast?”

Inside the black box: The credit channel of monetary policy transmission,”

Investigating inflation persistence across monetary regimes,” ECB Working

Liquidity shocks and asset price boom/bust cycles,” ECB Working Paper 732,

Monetary policy, output composition and the Great Moderation,” Federal Reserve Bank of Chicago WP

Mortgage markets, collateral constraints and monetary policy: Do institucional factors matter?” mimeo, European Central Bank.

Optimal monetary policy with durable and nondurable goods,” Federal Reserve Board,

Predicting US recessions: Financial variables as leading indicators,” The Review of Economics and Statistics,

The role of housholds’ collateralized debts in macroeconomic stabilisation,”

What drives personal consumption? The role of housing and financial wealth,” mimeo,

Housing is the business cycle: commentary

http://www.kansascityfed.org/publicat/sympos/2007/pdf/Smets_0415.pdf

Housing is the business cycle: commentary

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics