Systematic Monetary Policy and the Macroeconomic Effects of Shifts in Loan-to-Value Ratios

What are the macroeconomic consequences of changing aggregate lending standards in residential mortgage markets, as measured by loan-to-value (LTV) ratios? Using a structural VAR, we find that GDP and business investment increase following an expansionary LTV shock. Residential investment, by contrast, falls, a result that depends on the systematic reaction of monetary policy. We show that, in our sample, the Fed tended to respond directly to expansionary LTV shocks by raising the monetary policy instrument, and, as a result, mortgage rates increase and residential investment declines. The monetary policy reaction function in the US appears to include lending standards in residential markets, a finding we confirm in Taylor rule estimations. Without the endogenous monetary policy reaction residential investment increases. House prices and household (mortgage) debt behave in a similar way. This suggests that an exogenous loosening of LTV ratios is unlikely to explain booms in residential investment and house prices, or run ups in household leverage, at least in times of conventional monetary policy.