Friday, September 3, 2010

What Role Did the Fed Play In the Housing Bubble?

I really did not want to revisit this question since  I have already covered  it here many times before.  Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played  by the Fed's low interest rate policy.  I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it  does appear  to be one of the more important ones.  Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.  It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative.  Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential).  There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007).  Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa.  This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.


(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates.  The low interest rates  at the time encouraged investors to take on riskier investments than they otherwise would have.  Some of those riskier investments end up being tied to housing.  Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.  The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:



For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

Update: An good question was raised in the comments section: if the federal funds rate was below the neutral rate for so long, then why was there disinflation? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it should have been less concerned since it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point.  It shows the productivity surges at this time coincided with the two sustained drops in inflation while demand growth surged. (Click on figure to enlarge.)



10 comments:

  1. If the interest rate was held so far below the natural rate for so long, then how come there was no major acceleration of inflation?

    And why were longer-term interest rates so low? Surely the market couldn't have expected the Fed to continue holding the short-term rate below the natural rate for a decade.

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  2. The thing that leaves me questioning this theory is that it doesn't fully address the internatiional scope of the housing and credit bubble. I would love to see these estimates applied to Spain, Ireland and Britain as well. Not to mention non-bubble countries like Japan, China and Germany.

    The credit was not coming from Americans it was coming from outside the US, as in Spain and Ireland. That's why Bernanke's CAD chart is so compelling.

    Implicit in your theory is that the CAD was driven by loose monetary policy, which is plausible. But why did the currency not adjust?

    In China's case we know the answer, ditto the oil states, 30% of our trade partners on a trade weighted basis have fixed exchange rates. Similarly, other Asian countries were determined to accumulate dollars. Elswhere you've argued the Euro and Japanese monetary policy moves in sympathy with the US policy.

    In short, in a construct where the US has an effectively non-floating exchange rate and is stuck in a supremely non-optimal currency area I do not see a monetary path or scenario that ends well.

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  3. Andy:

    The productivity boom is why the inflation rate was so low. In fact, a big part of the story I didn't address in the post is that the deflation scare of 2002-2003 was simply a misreading of the deflationary tea leaves. The Fed saw the disinflation and thought weak aggregate demand(AD). Instead, it should have thought positive aggregate supply shocks given the 2002-2004 productivity boom. I have put up a figure in the post to illustrate this point.

    Given the productivity boom, much of the concern about the negative output gap was misplaced too. This negative output gap was largely the result of the new economic capacity created by the productivity boom. This is far different than a negative output gap created from a collapse in AD. It makes sense to have monetary policy close an output gap caused by a collapse in AD makes sense (like now). But there is less merit for doing so for one caused a productivity boom.

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  4. OGT,

    I agree, the Bretton Woods II arrangement really is not optimal and will continue to present problems to the global economy.

    To be clear, I am not arguing all of the "saving glut" was recycled U.S. monetary policy. Some of it would have occurred had there been no loose U.S. monetary policy.

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  5. Andy Harless said: "If the interest rate was held so far below the natural rate for so long, then how come there was no major acceleration of inflation?"

    Is it possible there are two natural, risk-free, overnight interest rates? One is for price inflation, the other is for asset price inflation? If the two are different, is that a sign of an imbalanced economy?

    Also, does positive productivity growth and cheap labor (outsourcing, legal immigration, and illegal immigration) produce price deflation in some prices?

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  6. Andy Harless said: "And why were longer-term interest rates so low? Surely the market couldn't have expected the Fed to continue holding the short-term rate below the natural rate for a decade."

    Why not as long as there is excess supply from china and a pegged currency? I think I am saying the natural rate for price inflation was low.

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  7. David Beckworth said: "This is far different than a negative output gap created from a collapse in AD. It makes sense to have monetary policy close an output gap caused by a collapse in AD makes sense (like now). But there is less merit for doing so for one caused a productivity boom."

    Does that apply for a "cheap labor" shock too?

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  8. I'm going to try to sum it up like this.

    If positive productivity growth and cheap labor produce price deflation, should the fed attempt to create more private debt to fight it?

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  9. The UK and the Eurozone held their rate *above* the natural interest rate - and housing market bubbles spouted up in varying degrees. Perhaps interest rate policy is overstated, then?

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  10. R.B. and OGT,

    trade deficit = gov't deficit plus private deficit

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