Figure 1
Federal Funds Rate and Inflation Targets
Source: Federal Reserve Bank of St. Louis, Monetary Trends (October 2008).
cent vs. 5.84 percent).2 Not surprisingly,
Figure 1). The diagram shows that the gap was
especially large--200 basis point or more--
increasing numbers of new mortgage borrow-
from mid-2003 to mid-2005.
ers were drawn away from mortgages with 30-
The demand bubble thus created went
year rates into ARMs. The share of new mort-
heavily into real estate. From mid-2003 to mid-
gages with adjustable rates, only one-fifth in
2007, while the dollar volume of final sales of
2001, had more than doubled by 2004. An
goods and services was growing at 5 percent to
adjustable-rate mortgage shifts the risk of refi-
7 percent, real estate loans at commercial
nancing at higher rates from the lender to the
banks were growing at 1017 percent.1 Credit-
borrower. Many borrowers who took out
fueled demand pushed up the sale prices of
ARMs implicitly (and imprudently) counted
existing houses and encouraged the construc-
on the Fed to keep short-term rates low indef-
tion of new housing on undeveloped land, in
initely. They have faced problems as their
both cases absorbing the increased dollar vol-
monthly payments have adjusted upward. The
ume of mortgages. Because real estate is an
shift toward ARMs thus compounded the
especially long-lived asset, its market value is
mortgage-quality problems arising from regu-
especially boosted by low interest rates. The
latory mandates and subsidies.
housing sector thus exhibited more than its
Researchers at the International Monetary
share of the price inflation as predicted by the
Fund have corroborated the view that the Fed's
Taylor Rule.
easy-credit policy fueled the housing bubble.
The Fed's policy of lowering short-term
After estimating the sensitivity of U.S. housing
interest rates not only fueled growth in the
prices and residential investment to interest
dollar volume of mortgage lending, but had
rates, they find that "the increase in house
unintended consequences for the type of mort-
prices and residential investment in the United
gages written. By pushing very-short-term
States over the past six years would have been
interest rates down so dramatically between
much more contained had short-term interest
rates remained unchanged."3 Even Alan Green-
2001 and 2004, the Fed lowered short-term
rates relative to 30-year rates. Adjustable-rate
span, who otherwise protests his innocence,
mortgages (ARMs), typically based on a one-
has acknowledged that "the 1 percent rate set
year interest rate, became increasingly cheap
in mid-2003 . . . lowered interest rates on
relative to 30-year fixed-rate mortgages. Back
adjustable-rate mortgages and may have con-
in 2001, nonteaser ARM rates on average were
tributed to the rise in U.S. home prices."
1.13 percent cheaper than 30-year fixed-mort-
The excess investment in new housing has
gages (5.84 percent vs. 6.97 percent). By 2004,
resulted in an overbuild of housing stock.
as a result of the ultra-low federal funds rate,
Assuming that the federal government does
the gap had grown to 1.94 percent (3.90 per-
not follow proposals (tongue-in-cheek or other-
4