The Taylor Rule & The US Housing Market

Posted on December 14, 2008


(Author’s note: This article was published on Seeking Alpha on December 26.)

I received a link to this article on Twitter from Paul Kedrosky, author of Infectious Greed, on John Taylor’s criticism of the Federal Reserve’s recent monetary policy. I was drawn to the post because of the chatter that I hear from residential mortgage brokers applauding cheaper money (a.k.a. lower interest rates) — their belief that sub-5% mortgage rates will spur housing demand. (Much more on this shortly…)

The article described Taylor’s criticism as published in his most recent paper. This is particularly poignant because this criticism comes from John Taylor of the Taylor Rule.

The Taylor Rule is a simple rule for determining the federal funds rate:

Nominal Rate = Inflation + 2.0 + 0.5(Inflation – 2.0) – 0.5(GDP gap)

Using the Taylor Rule, the current federal funds rate would be calculated at approximately 4.5% (assuming that a natural rate of GDP growth is 3.5%, with inflation calculated in October 2008 at 3.66% and current GDP growth at -0.5%).

With current rates well under 2% and looking at a historical graph of the Federal Funds Rate since 2000, we are still well below the level estimated by the Taylor Rule and have been for several years, thus the reason for Taylor’s scorn.

Going back even further to the 1990’s, we see that that Federal Funds Rate more closely followed the Taylor Rule recommendation:

(Source: Gregory Mankiw’s “Macroeconomics” 4th edition)

It was the Federal Reserve’s policy starting in 2001 that irked Taylor, to put it lightly. More so, The Federal Reserve has been dropping it’s target Federal Funds rate lately in an effort to combat recessionary pressures. This has perceived implications in the real estate industry by many mortgage brokers out there, as mentioned above.

Here’s the catch – the demand for money in the housing market is probably not the problem right now, because the aggregated buyer demand will not change unless lending requirements change at the current price levels. There are a fixed number of buyers in the market to which lenders will approve and make loans. Lenders are offering few indications that they will be loosening lending requirements in the near future, and so we can’t expect new buyers to enter the market simply with cheaper money available.

However, there are buyers at lower home price levels that would qualify for a loan if the overall price of homes were lower. For example, assume that there is a fixed supply of homes on the market (say 1,000,000 homes) and assume that all of these homes were all priced at $250,000. There are a certain number of buyers that are willing and able to buy a home at this price (meaning that they are actually receiving loan approvals), but given the surplus of inventory on the market, it appears that the number of buyers is below our assumed supply of 1,000,000 homes.

Now, if the price of these 1,000,000 homes for sale dropped to $200,000, then basic economics tell us that more buyers become willing and able to buy homes. That is, some buyers that would not be approved to purchase a $250,000 home would be approved to buy a $200,000 home, simply because income requirements are lower for the buyer at the lower home price. The profile of the buyer doesn’t change for the lender under their stricter lending requirements – strong credit scores and meeting income level requirements – there’s just more buyers when home prices drop overall.

The cheaper money will decrease the final price of homes to the eventual buyers, even if the actual sold price of homes does not change. This is because the lower interest rates will result in a lower long term mortgage payment. As many Realtors have told their buyer clients – the final price of the home matters far less to you monthly than does the monthly payments that you will be making for the next 30 years. That said, lowering interest rates to make money less expensive won’t spur housing demand in a drastic way.

This would indicate that the fundamental issue in the housing market is total quantity of homes demanded from qualified buyers as determined by the money suppliers – banks and lenders. Only buyers that will be approved are part of the buyer pool, the rest are just lookers. With more stringent (and responsible) lending requirements, the question is whether the true number of buyers in the market is numerous enough to purchase the existing supply. Given that suppliers (home sellers) are continuing to drop their prices, it would appear that the real number of qualified buyers are less that required for the housing market to find equilibrium.

Here’s an illustration of this example, courtesy of my AltosXplorer application from Altos Research (shameless plug):

This graph illustrates the point of fixed supply and declining prices. Using a 90-day rolling average value for both Median Price and Inventory, we can see that Inventory has mostly leveled off since the end of 2007, but prices are still falling at a constant rate. There’s just no buyers for the homes on the market at the price levels. As such, the suppliers (home sellers) are adjusting their price until they will reach a clearing price where willing, able, and funding-approved buyers will enter the market and begin purchasing homes.

To bring this back to John Taylor and his target for the Federal Funds rate – the problem with the housing market will likely not be improved with a decrease of interest rates, and cheap money bears considerable responsible for the housing price mess. Instead, long-term relief has better prospects with lower price levels that will clear the market.

Just one man’s perspective.