History seems to be repeating itself as rising home prices are not leading to a reduction in unemployment as quickly as market strength may indicate, possibly creating another housing bubble, said Bank of America Merrill Lynch in its latest report. 

Thus, contrary to market anticipation of a quick end to the open-ended third round of the quantitative easing program, the Federal Reserve will be slow to end the program due to recent strength in housing as home price growth exceeds expectations.

William Dudley, president and chief executive officer of the Federal Reserve Bank of New York confirmed this Monday during his speech, saying the central bank should continue its asset purchases as market recovery will take time to develop.

“In particular, the FOMC’s statement that purchases will continue until the labor market outlook improves substantially provides additional support for the recovery by reducing downside tail risk,” he said.

Dudley added, “In my view, we should calibrate the total amount of purchases to that needed to deliver a substantial improvement in labor market conditions, by allowing the flow rate of purchases to respond to material changes in the labor market outlook.”

For as much as quantitative easing may appear to be working at reducing unemployment, many question how exactly it’s supposed to be working and what the long-term costs to the policy might be, BofAML noted.

“In particular, by virtue of its willingness to purchase large amounts of treasury and mortgage debt at historically low yields, the Fed appears to be condoning further expansion of such debt, with the obvious irony that it was the expansion of such debt, most notably mortgage debt, that created the crisis in the first place,” said strategists Chris Flanagan and Matthew Carr of () (BAC)

As a result, the analysts at BofAML created a model that discerned whether the central bank, by targeting the mortgage rate and home prices through its mortgage-backed securities purchases, would be able to successfully lower the unemployment rate.

Based on the results, the model posted a similar experience in the early 2000s, suggesting a much quicker decline in the employment rate over the past three years than has actually occurred.

“If it is accepted that the Fed is creating asset inflation, most notably in housing, in order to lower the unemployment rate, then it appears as if the mistakes of the early 2000s are indeed being repeated,” the analysts said.

In particular, the traction between debt, asset inflation and employment that was present in the pre-2000 period appears to no longer exist, meaning the Fed will have to generate significant asset inflation in housing to reach the desired targeted rate of a 6.5% unemployment rate.

“According to our model, we should be at the Fed’s target already, but we of course are not. In other words, regardless of whether the policy is working as effectively as might have been hoped, it will continue nonetheless,” the analysts explained.


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