What Should Monetary Policy Have Been After the Bubble

1
What Should Monetary Policy Have Been After the
Bubble?

• October 2004
• J. Bradford DeLong
• U.C. Berkeley
• PRELIMINARY AND INCOMPLETE

2
The Stock Market Since 1995

• The steep decline in stock market values since
  2000 cannot be attributed to bad news about macro
  productivity
• It cannot be attributed to bad news about macro
  long-run real interest rates
• It did carry with it information about the likely
  willingness of businesses to keep on investing at
  their late-1990s pace

3
Alan Greenspans Reaction

• The FOMCs reaction to the crash of the NASDAQ
  (and to 911) was a very rapid reduction in the
  Federal Funds rate.
• A reduction that essentially left the FOMC out of
  ammunition (save for open-mouth operations) by
  the middle of 2003.
• A reduction that has only recently been moderated.

4
Four Views of the FOMCs Actions

• The production view the FOMC went a bit too far
• The unemployment rate view the FOMC was prudent
• The payroll employment view the FOMC was not
  aggressive enough
• Let me briefly run through these
• But I want to concentrate on a fourth view
• The housing bubble view

5
The Inflation View

• Inflation was high enough at the end of the
  decade for the Federal Reserve to welcome the end
  of the boom
• Inflation was low enough in 2002 for the FOMC to
  begin to fear deflation
• The inflation view suggests that if the FOMC
  moved too far, it did not take many extra steps

6
The Real Production View

• There was a sharp growth slowdown, but barely a
  recession.
• The past two years have seen American real GDP
  grow at a healthy pace.
• If you believe that the bubble was leading to
  overinvestment because it was transmitting
  false price information, then perhaps the FOMC
  moved too far

7
The U.S. Recovery Productivity

• Productivity growth averaged 1.2 per year from
  1973-1995.
• Productivity growth averaged 2.3 per year from
  1995-2001.
• Productivity growth has averaged 4.2 per year
  since the start of 2001.
• This extraordinary burst of productivity growth
  accounts for why employment yardsticks give
  different assessments of monetary policy than do
  output yardsticks

8
The Unemployment Rate View

• If you believe the decline in the labor force
  share of the adult population is a structural
  phenomenon, then the FOMC looks just right
• The unemployment rate did not rise very far
• And it has come down significantly since early
  2003

9
The Employment View

• Payroll employment still well below business
  cycle peak.
• Assume (for no good reason) last peak was 1.5
  million above full employment population
  growth since leaves the U.S. today some 4.9
  million below full employment.
• Implication the FOMCs monetary policy was in
  some sense not loose enough in the early 1990s

10
The Housing Price View

• OFHEOs house price indexes continue to rise
  through the recession and recovery
• Stock market decline a business phenomenon only
• Caveat housing is a long-duration, only partly
  reproducible asset
• If not reproducible, duration of 40?
• Argument that the FOMCs loose monetary policy
  has set off a housing bubble (or a housing plus
  bond market bubble)

11
The View Illustrated I Dean Baker

• Survivors of the recent stock market crash should
  rightly be worried that a sharp drop in housing
  prices could deliver a second major blow to their
  retirement dreams. The fact that there has been
  an unprecedented run-up in home prices over the
  last eight years creates the possibility for an
  unprecedented decline in the years ahead - just
  as the spurt in the NASDAQ at the end of the
  nineties created the basis for its plunge after
  March of 2000.
• The basic facts are striking. According to the
  government's House Price Index (HPI), the
  increase in the sale price of an average house
  has exceeded the overall rate of inflation by
  more than 40 percentage points over the last
  eight years.
• The fact that people are borrowing against their
  homes at a rapid rate (more than 750 billion in
  2003) is more evidence of an unsustainable
  bubble. The ratio of mortgage debt to home equity
  is at record highs but the nation's
  demographics (with the baby boomers approaching
  retirement) suggest that many homeowners should
  have largely paid off their mortgages.
• The market is responding to the housing bubble
  exactly as economic theory would predict. New
  homes are being built at record rate, far faster
  than can be supported by population and income
  growth. At the moment, this has mostly affected
  the rental market, leading to record vacancy
  rates and falling rental prices.
• The end result will be a loss of 2 to 3
  trillion in housing wealth, and a downturn that
  is even worse than the fallout from the stock
  market crash.

12
The View Illustrated II Michael Mussa

• The very low level of policy interest rates is an
  imbalance (relative to normal conditions) that
  reflects exceptionally easy monetary policies to
  combat economic weakness. This policy imbalance
  poses an important challenge for the future
  conduct of monetary policy.
• Situations of low policy interest rates and low
  inflation tend to be associated with high
  valuations of equities, real estate, and
  long-term bonds, which can become fertile ground
  for large, unsustainable increases in asset
  prices.
• If monetary policy is tightened too much too soon
  (perhaps because of worries about unsustainable
  increases in asset prices), the result can be an
  unnecessary asset market crunch and economic
  slowdown, and monetary policy may have relatively
  little room to ease in order to counteract this
  outcome.
• If monetary policy remains too easy for too long
  (perhaps because subdued general price inflation
  gives no clear signal of the need for monetary
  tightening), then large asset price anomalies may
  develop before corrective action is taken.
• The monetary authority would then confront the
  grim choice of trying to keep an unsustainable
  asset price bubble alive or trying to combat the
  collapse of such a bubble without a great deal of
  room for monetary easing.
• Interest rate spreads for emerging market
  borrowers have contracted substantially and flows
  of new credit have increased. The boom in
  emerging market credit has not yet reached the
  frenzy of the first half of 1997, but it is
  headed in that direction. By 2005 or 2006,
  however, either upward movements in industrial
  country interest rates or deterioration of market
  perceptions of the economic and financial
  stability of some emerging market countries could
  trigger another round of crises.

13
The View Illustrated III Pam Woodall

• MOST American economists will tell you that the
  Federal Reserve did a brilliant job in preventing
  a deeper and longer recession after the
  stockmarket bubble burst
• The gap between income and spending has been
  financed by saving less and by borrowing. Thanks
  to low interest rates the price of assets,
  especially homes, has risen steeply, which has
  made households feel richer and encouraged them
  to spend
• The Fed and others like to explain that there is
  no need to fret about the recent build-up of debt
  because it has been matched by big gains in the
  value of household assets such as shares and
  homes. The snag is that rising home prices do
  not increase real wealth for society as a whole.
  For a given housing stock, when prices rise, the
  capital gain to home-owners is offset by the
  increased future living costs of non-home-owners
• Moreover, the prices of assets can fall. Debts,
  on the other hand, are fixed in value. The
  housing stock has been turned into a gigantic
  cash machine. In the long run, the only way to
  create genuine wealth is to consume less than
  your income (ie, save), and invest in real
  income-creating assets. But America and some
  other economies have been enjoying a very
  different sort of wealth creation central banks
  are, in effect, printing wealth by running lax
  monetary policies. Illusory paper wealth is
  boosting consumption at the expense of saving.
  America's net national saving rate, the share of
  income that Americans are putting aside for their
  future, has fallen to a record low, just when
  they should be saving more to prepare for an
  ageing society
• Households expectations of continuing big gains
  in the price of houses and shares are highly
  unlikely to be met. The average ratio of house
  prices to incomes is already at a record level
  (see chart 13), yet people are buying homes in
  the unrealistic hope of large future price rises.
  That is the definition of a bubble. When two
  American economists, Robert Shiller and Karl
  Case, surveyed home-buyers in Los Angeles,
  Boston, San Francisco and Milwaukee last year,
  the respondents said they expected the value of
  their homes to rise at an annual average rate of
  12-16 over the next ten years
• In recent months adjustable-rate mortgages have
  accounted for half of all new mortgages in
  America
• The longer that home prices go on rising, the
  steeper their eventual decline will be

14
The View Summarized

• The FOMCs rapid interest rate reductions did
  indeed keep the stock market decline from having
  much larger macroeconomic effects
• Lower interest rates supported equity values and
  prevented credit-channel problem from reducing
  production.
• Lower interest rates on the money side made
  durable investments--especially in residential
  construction--more attractive.
• Lower interest rates that boosted home values
  induced waves of refinancing and expanded
  consumer spending.
• The FOMCs twist of the intertemporal relative
  price structure did indeed keep the collapse of
  the NASDAQ bubble from causing an economic
  depression.
• But the FOMCs twist of the intertemporal
  relative price structure has now created a bigger
  problem it has created a housing (and a bond
  market?) bubble
• Lower interest rates induced price runups
• Price runups attracted positive-feedback traders.
• High positive-feedback trading pushed prices up
  even more.
• Eventually this housing (and bond?) bubble will
  pop--and when it does, we will be in
  significantly worse shape than we would have been
  had the FOMC taken preemptive action in 1998-2000
  to prevent the stock market bubble from gathering
  force.

15
The View Modeled?

• This view has many strong adherents among people
  writing about the economy--and making
  investments--outside of economics departments.
• Mussa (2004) is the closest thing I can find
  within the academic economics community.
• This view is not one we find easy to model
• Widespread irrationality
• Lack of the short interest that should push
  prices to reflect consensus or average
  expectations
• Lots of 50 bills left on the sidewalk
• I think we need to figure out how to model things
  like this if we are to participate in the
  discussion
• If we dont succeed in modeling it, we cannot
  even say that it is (as I think it is) an
  unlikely scenario.

16
What Would a Model Look Like?

• Bernanke-Gertler credit channel
• Two major assets
• Business equities (which serve as effective
  collateral to keep the credit channel from
  gumming up business loans on the
  business-investment side)
• Consumer houses (which serve as effective
  collateral to keep the credit channel from
  gumming up consumer loans on the
  consumption-spending side)
• Two asset markets linked because valuations are
  both affected by monetary policy
• A bad shock to business equity values calls forth
  interest rate reductions to keep credit-channel
  problems from developing on the
  business-investment side
• But then induces a behavioral-finance
  phenomenon--a lot of households buying bigger
  houses and then leveraging themselves up as
  housing prices rise
• Followed (someday) by a pop of the bubble and
  credit-channel problems on the consumption-spendin
  g side