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For release on delivery Expected 2:30 p.m. E.S.T Statement by J. Charles Partee Member, Board of Govnmors of the Federal Reserve System before the Joint Economic Committee April 16, 1980 I am pleased to appear today on behalf of the Federal Reserve Board to discuss the subject of housing and the economy. timely focus of inquiry. This is an appropriate and Problems in housing often are considered in isolation from the rest of the economic system. Though that is at times the relevant focus, under current circumstances it seems to me important that the short term situation of housing and housing finance be evaluated in the light of overall economic activity and national policy objectives. Conditions in the mortgage and housing markets have deteriorated sharply in recent months and residential construction activity now seems likely to decline to relatively low levels for much or all of the remainder of this year. Most of the decline, of course, has occurred since last October when the Federal Reserve announced a number of important policy changes. That package of measures was designed to give the Federal Reserve better control over aggregate flows of money and credit, and the further actions taken in mid-March are intended to reinforce the credit restraining aspects of that effort. Up until now, unfortunately, overall credit demands have remained exceedingly strong, reflecting the persistent strength of inflation and widespread inflationary psychology as well as a continuing high level of aggregate economic activity. With strong credit demands pressing against limited supplies, financial markets have tightened substantially, interest rates have risen sharply, and housing starts and home sales have plummeted. The overriding objective of recent Federal Reserve policy actions has been to reduce inflationary pressures in the economy— pressures that have intensified steadily over the past year. Inflation weakens the value of the dollar at home and abroad, diverts attention from productive to non-productive pursuits, and inevitably creates a host of economic and social distortions, imbalances, and -2- inequities. Indeed, mortgage and housing markets have not been free of a pattern of speculative and anticipatory behavior that could threaten seriously destabilizating consequences over the longer term if inflation and inflationary expectations are not restrained. The Board believes that the long-run benefits to be derived from containing inflation will far outweigh the short-run costs incurred in housing and other markets. Inflation has produced serious problems also for the nonbank thrift institutions and for other types of investors that concentrate their holdings in longer term instruments bearing fixed interest rates. With the increase in actual and expected inflation rates, nominal interest rates have risen apace as lenders have sought to protect the purchasing power of their dollars and borrowers have been willing to pay higher inflation premiums. Consequently, high-quality loans, made in the past at the lower interest rates of the time, have become burdens for institutions that had followed prudent business practices and provided the useful service of maturity intermediation— borrowing short term from savers and making long-term funds available to borrowers. Savings inflows to these institutions have slowed markedly, even though the average effective rate paid for funds has moved substantially higher, so that the interest and participation of such institutions in the mortgage market has been on the decline. The effects of inflation have not been restricted to the supply side of the mortgage markets. The inflationary process clearly has influenced the behavior of home buyers and mortgage debtors also, causing some distortions within this market and affecting patterns of household savings and investment. High rates of inflation, in conjunction with the tax system, have enhanced the appeal of homeownership, made rental housing less attractive to investors, -3- and stimulated the conversion of rental projects to condominium ownership status— creating hardships for some tenants. The strong demands for homes have pulled house prices up at a pace that, until recently, was well above the increase in broad-based price indexes, making it increasingly difficult for new entrants to achieve homeownership. And since many homeowners apparently have viewed unrealized capital gains as an important supplement to their wealth, they have been inclined to consume larger proportions of disposable personal income, incur larger debts, and accept less liquid balance sheet positions. The demand for home mortgage credit remained historically quite strong until late last year, despite the fact that mortgage interest rates had risen to postwar highs. Prospective capital gains on homes and expectations of rising nominal income encouraged buyers to commit unusually large shares of their current income to mortgage payments. Since last October, however, mortgage credit demand has weakened as mortgage rates have risen sharply further and the availability of credit has become constrained. Indeed, many prospective buyers have been unable to meet more stringent lender standards concerning acceptable ratios of mortgage payments to borrower income. The effects of general monetary restraint customarily fall quite heavily on the mortgage and housing markets, and the Federal Reserve Board has consistently supported and recommended measures that would spread the burden of credit restraint more evenly throughout the economy. For example, it makes good sense to remove artificial interest rate constraints on the flow of mortgage funds and to free gradually local depositary institutions from the interest rate ceilings that prevent them from competing in the markets for savings. Institutional adjustments designed to permit mortgage borrowers to compete more effectively for funds with other participants in the long-term -4- debt markets also seem highly desirable. Mortgage passthrough securities have been a particularly important innovation, providing a way for home buyers indirectly to raise mortgage funds on reasonably favorable terms in the national capital markets. Local lenders also have obtained funding from the impersonal national markets for large CD's and commercial paper far more than before, while continuing their active use of traditional nondeposit sources— primarily Federal Home Loan Bank advances and sales of mortgages in the secondary market to FNMA and others. The nonbank thrift institutions, of course, can not be insulated from the effects of rising market interest rates. Earnings on thrift portfolios have not risen in line with market rates because of the preponderance of long-term fixed-rate assets acquired in past periods. Recent experience has clearly demonstrated the need for more variable yields on assets held. If the thrift institutions are to continue their emphasis on mortgage financing, that attribute of rate flexibility will be required more commonly in the mortgage instrument as well. The Federal Reserve has long supported the expanded use of variable-rate mortgages, with appropriate consumer safeguards, and has endorsed the Bank Board's authorization of renegotiable-rate or "rollover" mortgages for use by the savings and loans. The need for these types of mortgage instruments Is even more pressing now that Congress has legislated a phase-out of deposit rate ceilings. Meanwhile, we at the Board are acutely aware of the recent drying up 1n mortgage money. In designing the Special Credit Restraint Program announced March 14, banks were asked to give priority attention to maintaining a reasonable availability of funds to small businesses, such as local builders, and to serving the liquidity needs of their thrift institution customers. The special deposit -5- requlrements placed on increases in consumer credit specifically exclude from coverage credit that is extended for the purchase or improvement of homes. Finally, the special deposit requirements imposed on any further expansion in the assets of money market mutual funds should help limit the massive recent movement of savings toward the central money market, thus leaving more funds available in local markets to help meet local credit demands, including those associated with housing. Nevertheless, with mortgage interest rates at their current extraordinary level, it seems clear that many prospective borrowers will defer home purchases and remain in their present accommodations until con ditions become more favorable. Mortgage lenders and home builders, correspondingly, will experience considerably reduced levels of activity. This situation is likely to be relatively short-lived, however, and it is well to remember that these industries have often before demonstrated their ability to snap back after periods of tight credit. The Congress may wish, of course, to consider special programs to aid housing through this current difficult period. In any such consideration, we would urge that the benefits expected from specific measures be carefully weighed against the likely costs. The types of programs used in the last housing downswing to provide mortgage credit to homebuyers at below-market interest rates undoubtedly would provide some support for housing activity in the short run. On the other hand, federal borrowing to finance these programs would tend to put further upward pressure on market Interest rates and could thereby intensify the problems being experienced by the thrift institutions. Use of special subsidy programs, moreover, would add to budgetary and/or Federal Credit program outlays and would logically call for offsetting cutbacks in other areas if the discipline of holding back on Federal expenditures as a part of the inflation fight is to be maintained. -6- In any event, short-run solutions designed to aid the mortgage and housing markets will not go to the core of the problem facing these and other sectors of the economy. In order to obtain lasting improvement, the inflationary process must be halted. As inflation abates and inflationary expectations dissipate, market interest rates will recede and pressures on the depositary institutions will ease. The Federal Reserve role in assisting this process must be to restrain growth in money and credit to rates consistent with the longer-run needs of the economy. Our suecess in holding to this course, I believe, will constitute the best hope for restoration of stable, viable housing and residential mortgage markets that will serve the growing needs of our population. # # # # # # # # # # # # # # #
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