In this case, the “what if” question might be, “What’s the likely effect if national house prices did fall by 25 percent, enough to bring the price-to-rent ratio back to its historical average?” Before going any further, I want to emphasize that I’m not making any predictions about house price movements, but instead, simply discussing how a prudent monetary policymaker could assess the risk. First, there would be an effect on consumers’ wealth. With housing wealth nearing $ trillion today, such a drop in house prices would extinguish about $ trillion of household wealth—equal to about 38 percent of GDP. Standard estimates suggest that for each dollar of wealth lost, households tend to cut back on spending by around 3½ cents. This amounts to a decrease in consumer spending of about 1¼ percent of GDP. To get some perspective on how big the effect would be, it’s worth comparing it with the stock market decline that began in early 2000. In that episode, the extinction of wealth was much greater—stock market wealth fell by $ trillion from March 2000 to the end of 2002. This suggests that if house prices were to drop by 25 percent, the impact on the economy might be about half what it was when the stock market turned down a few years ago. Moreover, the spending pullback wouldn’t happen all of a sudden. Wealth effects—positive or negative—tend to affect spending with fairly long lags.
Finally, while business investment in equipment and software rose strongly last year, by almost 14 percent, the level of investment is still not as high relative to GDP as we’d expect, given favorable economic conditions and firms’ healthy balance sheets. Economic growth has been solid for a few years now. And, with the very low level of interest rates, borrowing costs can’t be the problem. Moreover, profit margins have been high for some time, so firms are certainly not strapped for cash. The shortfall might be due to business caution, perhaps related to reverberations from 9/11 and subsequent terrorist threats and actions or perhaps to the corporate governance scandals and the adjustments required by the legislation that followed them. Alternatively, the investment shortfall might reflect the perception by businesses that productivity gains can be realized at this stage that do not require major new investments in equipment and software. Whatever the explanation, the consequence of these drags is that the Fed had to keep interest rates exceptionally low for a long time just to get respectable, but not stellar, economic growth. In fact, the federal funds rate was lowered all the way to 1 percent and held there until the middle of last year. Since then, the FOMC has raised the funds rate nine times to 3¼ percent, but it still remains in a range normally considered stimulative. Bond rate conundrum Increases in the federal funds rate typically lead to increases in longer-term interest rates.