St. Louis Fed's Review: What Happens to Banks When House Prices Fall?; Recent Trends in Homeownership; Do Inflation Targeters Outperform Non-targeters?; A Close Look at Model-Dependent Monetary Policy Design

ST. LOUIS — The September/October issue of Review, the Federal Reserve Bank of St. Louis' journal of economic and business issues, features the following articles. The publication is also available on the St. Louis Fed's web site: www.stlouisfed.org.

"What Happens to Banks When House Prices Fall?" The recent, rapid appreciation of home prices in many U.S. communities has prompted concern regarding the possible effects of a sharp decline in prices, especially for commercial banks and other real estate lenders. Economist David C. Wheelock looks at the regional real estate booms and busts of the 1980s and 1990s to see if that pattern would hold true today. He finds that about half of state house price booms were followed by a severe decline in prices, but large declines occurred in several states that did not have a previous boom. Banks in states that had large house price declines experienced high default rates and, thus, low profit and high failure rates. Wheelock concludes that although U.S. banks may have become more exposed to residential real estate recently, they appear to be less vulnerable to a decline in home prices than banks in states with large price declines during the earlier period.

"Recent Trends in Home Ownership." After years of being relatively constant, the homeownership rate began to go upward in 1995, climbing close to 64 percent. The typical explanations for the rise include demographics, low mortgage rates, changes in housing policy, and innovations in the mortgage finance market. Economists Carlos Garriga, William T. Gavin and Don Schlagenhauf find that of all those, innovations in financial markets has increased access to mortgage finance, mainly by reducing downpayment constraints and allowing younger people to buy homes.

"Do Inflation Targeters Outperform Non-targeters?" Ten years of empirical studies of inflation targeting have not uncovered clear evidence that monetary policy that incorporates formal targets imparts better inflation performance. Economists Michael J. Dueker and Andreas M. Fischer survey the literature and find that the "no difference" verdict has been robust to a wide range of countries and methods of analysis. They conclude, however, that these findings to date do not rule out the possibility that formal inflation targets could prove pivotal if the global environment of disinflation were to reverse course.

"A Close Look at Model-Dependent Monetary Policy Design." Economist Miguel Casares explores the implications of model specifications on the design of targeting rules in a world of model uncertainty. As a general prescription, a targeting rule must counterbalance the private-sector dynamics: the more backward-looking behavior is observed in either the output gap or inflation, the more forward-looking monetary policy should be. Likewise, a more forward-looking economy would require stronger backward-looking reactions in the nominal interest rate to the output gap or inflation. Casares also analyzes the effects of implementing monetary policy in an uncertain environment.

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