June 29-30, 2005 1 of 234 Meeting of the Federal Open Market Committee on June 29-30, 2005 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., starting at 2:00 p.m. on Tuesday, June 29, 2005, and continuing at 9:00 a.m. on Wednesday, June 30, 2005. Those present were the following: Mr. Greenspan, Chairman Mr. Geithner, Vice Chairman Ms. Bies Mr. Ferguson Mr. Fisher Mr. Gramlich Mr. Kohn Mr. Moskow Mr. Olson Mr. Santomero Mr. Stern Ms. Cumming, Messrs. Guynn and Lacker, Mses. Pianalto and Yellen, Alternate Members of the Federal Open Market Committee Mr. Hoenig, Ms. Minehan, and Mr. Poole, Presidents of the Federal Reserve Banks of Kansas City, Boston, and St. Louis, respectively Mr. Reinhart, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Ms. Johnson, Economist Mr. Stockton, Economist Messrs. Evans, Freeman, and Madigan, Ms. Mester, Messrs. Oliner, Rolnick, Rosenblum, Tracy, and Wilcox, Associate Economists Mr. Kos, Manager, System Open Market Account Mr. Ettin, Deputy Director, Division of Research and Statistics, Board of Governors Messrs. Kamin, Slifman, and Struckmeyer, Associate Directors, Divisions of International Finance, Research and Statistics, and Research and Statistics, respectively, Board of Governors June 29-30, 2005 2 of 234 Messrs. Clouse, Wascher, and Whitesell, Deputy Associate Directors, Divisions of Monetary Affairs, Research and Statistics, and Monetary Affairs, respectively, Board of Governors Messrs. English, Leahy, and Treacy1, Assistant Directors, Divisions of Monetary Affairs, International Finance, and Banking Supervision and Regulation, respectively, Board of Governors Mr. Simpson, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Skidmore, Special Assistant to the Board, Office of Board Members, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Wright2, Section Chief, Division of Monetary Affairs, Board of Governors Messrs. Bowman2, Gallin1, and Lehnert1, Senior Economists, Divisions of International Finance, Research and Statistics, and Research and Statistics, respectively, Board of Governors Messrs. Doyle1 and Martin1, Economists, Division of International Finance, Board of Governors Messrs. Kumasaka1 and Luecke, Senior Financial Analysts, Division of Monetary Affairs, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Mr. Barron, First Vice President, Federal Reserve Bank of Atlanta Messrs. Eisenbeis and Judd, Executive Vice Presidents, Federal Reserve Banks of Atlanta and San Francisco, respectively Messrs. Fuhrer, Goodfriend, and Hakkio, Ms. Perelmuter, Messrs. Rasche, Rudebusch1, Sniderman, and Williams1, Senior Vice Presidents, Federal Reserve Banks of Boston, Richmond, Kansas City, New York, St. Louis, San Francisco, Cleveland, and San Francisco, respectively Mr. Peach1, Vice President, Federal Reserve Bank of New York 1 Attended Wednesday’s portion of the meeting. 2 Attended Thursday’s portion of the meeting. June 29-30, 2005 3 of 234 Transcript of Federal Open Market Committee Meeting on June 29-30, 2005 June 29—Afternoon Session CHAIRMAN GREENSPAN. Good afternoon, everyone. I think you all are aware that this is the last meeting Governor Gramlich plans to attend. There will be a luncheon in his honor after the meeting ends tomorrow. It’s also the last meeting for Ed Ettin, who will retire at the end of July, and for Marvin Goodfriend from the Richmond Bank, who will move to Carnegie Mellon at the end of the summer. We’ll miss all of them. Ed, as some of us know, has been attending FOMC meetings since the late 1970s, and Marvin has been attending since 1993. As for Ned, there are certain special things that I’m going to say about him tomorrow, which I won’t repeat here. We’ll let him be a little nervous. [Laughter] MR. GRAMLICH. I’ve got a few things to say, too. CHAIRMAN GREENSPAN. Ah, but I will have the gavel! The first item on the agenda is the selection of Richard T. Freeman as an Associate Economist of the FOMC to serve until the election of a successor at the first regularly scheduled meeting of the Committee in 2006. Would somebody like to move that nomination? MR. FERGUSON. I’ll move that nomination. CHAIRMAN GREENSPAN. Without objection, that is approved. We will be discussing a special topic today at your request, housing valuations and monetary policy. You’ve obviously received the documents the staff has distributed. Mine are buried in this stack here; I have them. Let’s turn now to Dave Stockton. MR. STOCKTON. Thank you, Mr. Chairman. We have five briefings this afternoon and the issues covered in those briefings are so intertwined that we thought it would be best if we just June 29-30, 2005 4 of 234 presented all five and then opened the floor for discussion and questions afterward. We recognize that a long presentation, coming right after lunch and while a number of you are still probably a bit jet-lagged, could test your powers of concentration, but I think you’ll find the presenters to be both well informed and entertaining. [Laughter] So with that we’ll begin. MR. GALLIN.3 Thank you. My presentation begins on the third page of the handout you received. It seems that everybody is talking about house prices, and the upper panel of your first exhibit shows why: House prices, adjusted for general inflation, have risen at a rapid pace in recent years and did not even pause during the last recession. Indeed, the real rate of appreciation has increased, and the most recent readings have been at annual rates greater than 7 percent. By comparison, the average annual increase in real house prices during the past 30 years is only about 1¾ percent. The next two panels illustrate some of the eye-popping gains that have been recorded in selected metropolitan areas. For example, as shown in the middle left panel, real house prices increased about 16 percent in San Francisco and 30 percent in Las Vegas during the four-quarter period ending in the first quarter; as shown to the right, the most recent gain was 13 percent in New York and 20 percent in Miami. Rapid price appreciation has sparked debate about whether housing has become overvalued, and the popular press is filled with stories suggesting that it has. As summarized in the lower left panel, anecdotes suggesting that the housing market is overheated include those about increased speculation, purchase decisions that are perhaps too dependent on rosy assessments of future appreciation, and increased reliance on novel forms of financing without full recognition of the associated risks. Although these anecdotes are suggestive, they do not provide a benchmark for valuing housing. Two approaches that do provide a benchmark are listed to the right. One is to ask if housing is affordable for a typical family. Some analysts have argued that prices are too high relative to incomes, while others say low interest rates have kept required monthly mortgage payments affordable. Another approach is to ask if house prices are properly aligned with rents. I have pursued both approaches in my research, and have concluded that rents provide a preferable benchmark for valuing housing. I will therefore focus my prepared remarks on this approach. As summarized in the upper left panel of your next exhibit, a strength of this approach is that it employs a standard asset pricing framework, such as that often used in studies of stock market valuation. In this framework, rental payments in the housing market are analogous to dividends in the stock market. Seen this way, the 3 The materials used by Messrs. Gallin, Lehnert, Peach, Rudebusch, and Williams are appended to this transcript (appendix 1). June 29-30, 2005 5 of 234 price of a house should reflect the appropriately discounted stream of expected rents; high prices could be justified by high rents or by low carrying costs, which include interest payments, net taxes, and depreciation. But if prices appear unusually high relative to rents and carrying costs, one might conclude that housing is overvalued. As highlighted to the right, I have implemented the framework using repeat- transactions price indexes from the Office of Federal Housing Enterprise Oversight [OFHEO] and Freddie Mac and the tenants’ rent index from the consumer price index. I made several adjustments to these series to address some of the shortcomings of the published data. As you will see in Dick Peach’s presentation, he and I disagree about the best way to measure house prices. I would be happy to discuss the issue during the question period. That said, the red line in the middle panel shows the estimated price-rent ratio for the stock of housing, and the black line shows the estimated real carrying cost of housing. The first point to note is that the measured price-rent ratio is currently higher than at any earlier time for which we have data. Moreover, the run-up in prices appears to be far greater than can be explained by carrying costs, at least if we use the historical relationship between the two series as our guide. Although theory suggests a tight link between carrying costs and the price-rent ratio, the data suggest that the actual link is more tenuous. At the simplest level, while the price-rent ratio is at a historical high, the carrying cost is not at a historical low. More formally, regression analysis suggests that prices are about 20 percent too high given rents and carrying costs. One might reasonably ask what this potential 20 percent overvaluation portends for house prices. The lower panel summarizes the historical experience on this question.