Saturday, June 16, 2007

Bernanke hints at thinking on housing

Bernanke hints at thinking on housing
By Krishna Guha in Washington
Copyright The Financial Times Limited 2007
Published: June 15 2007 21:13 | Last updated: June 15 2007 21:13

Changes in house prices could have a bigger effect on consumption than the traditional “wealth effect” suggests, Ben Bernanke said on Friday in comments that offer some insight into how the Federal Reserve may think about the continuing problems in the US housing market.

The Federal Reserve chairman told a conference hosted by the Atlanta Fed that, in addition to making homeowners richer or poorer, changes in house prices might influence the cost and availability of credit to consumers.

This is because people with equity in their homes have more at stake in avoiding default. That, in turn, reduces the premium char-ged by lenders owing to their imperfect knowledge of their borrowers’ financial circumstances.

If this theory is correct, Mr Bernanke said, “changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect”.

The Fed chief notes that this argument also indicates that the distribution of home price gains or losses matters for consumption. “The effect on aggregate consumption of a given decline in house prices is greater, the greater the fraction of consumers who begin with relatively low home equity,” he said.

This suggests the Fed may be relatively relaxed about declines in segments of the housing market where wealthy homeowners have a large stock of home equity, but more concerned about price falls in areas where people have little home equity. This is typically the segment with a high proportion of subprime loans.

In an economy such as the US where most mortgage contracts are still fixed-rate, the effect of house price changes on access to credit overall may be “muted”, he said. But consumers with adjustable rate mortgages – whose cash flow suffers when short-term interest rates go up – could see their access to credit deteriorate.

The Fed chief said he did not know whether the so-called “financial accelerator effect” on household spending via access to credit was big enough to affect the overall economy.

His remarks on housing came as he explored the ways in which changes in creditworthiness may amp-lify the effects of monetary policy as well as real economy shocks such as a shift in productivity. A rise in interest rates that reduced the value of companies assets and cash flows “would increase the effective cost of credit by more than the change in risk-free rates”.

Likewise, a rise in rates that negatively affected the balance sheet and cash flows of banks and other financial intermediaries would raise the cost of external finance.


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