Did low interest rates really cause the housing boom and bust?

Last week, the Federal Reserve released documents showing how sanguine officials were in the lead-up to the 2008 financial crisis. The Fed’s overly optimistic predictions about the housing market and the economy at large have prompted renewed scrutiny of the central bank’s role in enabling the pre-recession bubble through rock-bottom interest rates.
Federal Reserve Chairman Ben Bernanke. (Reuters )

But Kenneth Kuttner, an economist at Williams College, recently took a closer look at the evidence and came away unconvinced that the Fed actually catalyzed the housing boom. Instead, he finds that low interest rates had a relatively modest impact on housing prices during pre-crisis boom:

All available evidence — existing studies, plus the new findings presented above — points to a rather small effect of interest rates on housing prices. VAR-based estimates of the effect of a 25 basis point expansionary monetary policy shock range from 0.3% to 0.9%, both in the U.S. and in other industrialized countries....they are too small to explain the previous decade’s tremendous real estate boom in the U.S. and elsewhere.

This is not to say that low interest rates had nothing to do the real estate boom. The real UC of home ownership in the U.S. fell by roughly 0.8% after 2001, a change that appears to have been only partly attributable to monetary policy....But even if a robust inverse relationship between interest rates and house prices existed, it would not follow from that alone that low interest rates caused bubbles.

That said, Kuttner believes that the growing availability of easy credit, more broadly speaking, was probably more responsible in inflating housing prices.

The evidence presented in this paper also suggests that credit conditions, broadly defined, may play a larger role in house price booms than low interest rates per se. In market-oriented financial systems, like that of the U.S., a loosening of credit conditions plausibly resulted from financial innovation, such as securitization, and a relaxation of lending standards. ... This suggests that it would be a mistake to focus narrowly on interest rates as the cause of asset price bubbles.

So although the Fed might have helped “fan the flames,” as Kuttner writes, the financial firms that lowered their lending standards and securitized the subsequent mortgages were highly culpable.