Low interest rate conundrum and the housing froth

Brad DeLong tries to explain the low long-term interest rate conundrum.

Now what happens when the Federal Reserve raises short-term interest rates r? That narrows spreads between short- and long-term interest rates, and induces the hedge fund to increase its demand L for long-term Treasuries. That means that increases in short-term rates are associated with increased demand -- higher prices -- lower interest rates -- on long-term bonds. In other words, hedge-fund demand for long-term Treasuries slopes the wrong way: when prices rise, demand does not fall but increases.

So does Barry Ritholtz.

[U]nderfunded pensions have to buy long bonds. But hedge funds know this, and they "front run." That's even more buyers (on top of China and Japan) helping to drive rates lower...

The effect of low interest rates on the housing market obviously has Federal Reserve chairman Alan Greenspan worried. In his testimony to the US Congress yesterday, he said:

[T]here can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a "bubble" in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.

So no bubble yet, but some froth.

In a Bloomberg article, Caroline Baum compared the Fed chairman's recent actions on the housing market with his inaction during the 1990s stock market bubble.

Back in the go-go years of the late 1990s, when everyone with a crazy idea and dot-com domain name became a rock star, some economists encouraged the Federal Reserve to utilize one of its little-used tools to rein in the bubble in technology and Internet stocks [i.e. initial margin requirement]... In public, Fed chief Alan Greenspan dismissed the idea of raising margin requirements...to reduce speculation. He steadfastly maintained, even after the bubble burst, that identifying a bubble was possible only after the fact.

As reluctant as the Fed was in 1999 to use non-traditional policy instruments, six years later, with cumulating signs of a bubble in the housing market, the Fed is dipping into its tool chest for some moral suasion... That's exactly what the Fed and other bank regulators, including the Office of the Controller of the Currency and Federal Deposit Insurance Corp., resorted to on May 16 when they issued guidance to financial institutions "for sound risk management practices for home equity lines of credit and loans."

The difference in the reactions to the two situations is apparent to Baum.

Greenspan has gone from a bubble denier to a froth conceder. Other Fed officials now routinely mention the real estate market in their public appearances. So has Greenspan changed his view that bubble management is strictly an ex-post job for a central banker?

It certainly does look as though he has -- at least as far as his publicly-expressed view is concerned. And it wouldn't be too soon.