The Role of the Federal Reserve in the U.S. Housing Crisis: A VAR Analysis with Endogenous Structural Breaks

Mahua Barari,Srikanta Kundu

doi:10.3390/jrfm12030125

Abstract

This paper reexamines the role of the Federal Reserve in triggering the recent housing crisis. Specifically, we explore if the relationship between the federal funds rate and the housing variables underwent structural changes in the wake of the housing crisis. Using quarterly data spanning 1960–2017, we estimate a VAR model involving federal funds rate, real GDP growth and a housing variable (captured by house price inflation or residential investment share or housing starts) and conduct time series analysis for the pre- and post-crisis periods. While previous studies mostly set break-dates based on events known a priori to split the full sample to subsamples, we endogenously determine structural break points occurring at multiple unknown dates. Our Granger causality analysis indicates that the federal funds rate did not cause house price inflation, although it caused residential investment share and housing starts in the pre-crisis period. In the post-crisis period, the real GDP growth caused residential investment and housing starts while house price inflation had a momentum of its own. Our impulse response and forecast error variance decomposition analysis reinforce these results. Overall, our findings suggest that housing volume fluctuates more than house prices over the business cycle.

Highlights

There is a growing body of literature on the possible causes of the housing crisis of the past decade that eventually morphed into a full-blown recession during 2007–2009
Since structural stability in the relationship among variables is critical for such policy evaluation and analysis, we investigate if the relationship between the federal funds rate, real GDP and the housing variables has been stable for all time periods or if there have been structural breaks in the relationship over time
We focus on the stability of the relationship between monetary policy as measured by the federal funds rate and a combination of housing variables capturing both price and volume in the housing market spanning almost six decades

Summary

Introduction

There is a growing body of literature on the possible causes of the housing crisis of the past decade that eventually morphed into a full-blown recession during 2007–2009. There was a surge in interest in exploring the origin of this crisis to prevent its recurrence in future. Four possible explanations have been offered for the housing bubble which burst in 2006 (See McDonald and Stokes 2013c, 2015). There are those who blamed the financial innovations of the 1990s and early 2000s giving rise to lax credit standards and greater access to mortgage credit for high-risk subprime borrowers. Some researchers pointed to the growing US current account deficit requiring a massive capital inflow from abroad. The ‘global savings glut’[1] of the 1990s helped

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Conclusion