Interest Rates on Residential Housing: Another Lesson in the Limits of Monetary Policy

Another Lesson Serious People Didn't Want to Learn

Economics has two major policy tools at its disposal.  Fiscal policy is implemented by changing government spending and/or taxes.  By increasing spending or decreasing taxes expansionary fiscal policy will increase Aggregate Demand in an economy which will lead to higher employment and output than would otherwise occur.  Conservatives don’t like fiscal policy on philosophical grounds, because it requires active involvement of the government in the economy.

Monetary policy is implemented by changing to supply of bank reserves and influencing the rate of interest that borrowers pay to borrow money.  Conservatives generally like monetary policy (except when it is trying to support an economic recovery while Barack Obama is President, then they don’t like any constructive economic policy) because its effects are indirect. 

Unfortunately monetary policy is not symmetric.  Restricting the availability and supply of credit and raising interest rates can shut down an economy that is experiencing excess demand related inflation.  So the logical conclusion would be that increasing the availability and supply of credit and lowering interest rates would stimulate the economy.  That conclusion would be wrong.

The reason it is wrong is that low interest rates and high credit availability is a necessary but not sufficient condition for economic expansion.  Consumers will not spend more, and businesses will not invest more just because interest rates are low.  Consumers must have the income to be able to buy more, and businesses must have the prospects of higher sales in order to invest more.  If these conditions are not present, monetary policy will be largely ineffective in expanding economic activity.

Such is the case with housing.  Current mortgage rates have been falling for several years, and are currently at the lowest levels in decades.

the average interest rate on a 30-year fixed mortgage fell to 4.01% this week from 4.09% a week ago. This week's rate is the lowest since 1951.

The average rate on a 15-year fixed mortgage ticked down to 3.28%. Economists say that's the lowest ever for that loan.

So what is happening in the housing market?

low rates have so far done little to boost home sales or refinancing.

A second report Thursday said the number of Americans who signed contracts to buy homes fell in August, after a weaker-than-expected peak buying season.

The National Association of Realtors says its index of sales agreements fell 1.2% last month to 88.6.

A reading of 100 is considered healthy. The last time the index reached that level was in April 2010, final month that buyers could qualify for a federal tax credit that has since expired.

As for home sales, the record shows this

The pace of sales for previously occupied homes is slightly above last year's 4.91 million sold, which was the fewest since 1997. In a healthy economy, Americans would buy roughly 6 million homes each year.

In August, sales of new homes fell for a fourth straight month. This year is shaping up to be the worst for new-home sales on records dating to 1963.


Now one expected benefit of lower mortgage rates is that re-financing is possible.  This has the same economic effect as a tax cut, it can increase the disposable income of taxpayers by thousands of dollars a year.  Except, in the current situation so many houses are underwater, worth less than their current mortgage balance, that re-financing is not possible.  You cannot refinance a 6% mortgage into a 4% mortgage if the mortgage balance is $220,000 and the residence has a market value of $200,000.  So even this potential benefit of lower rates is reduced.

The conclusions are absolutely clear to everyone except those in economic policy positions.  Unless middle class income earners see an increase in their incomes, or expect an increase in their incomes and do not expect to lose their jobs, low mortgage rates will not increase home sales substantially.  And those conditions can only come from fiscal policy.

Lesson over, the quiz will be November 2012.  Most of the class is not expected to pass.