George perendia

Effects of infla.on targe.ng misfiring on development of housing market bubble

and its burs.ng in 2008 credit crisis

Author: George Perendia, LMBS e-‐mail: [email protected]

Background:

  The so called "years of great modera.on", the years of rela4vely stable and low infla4on since early 1980,

  a period of reduc4on in government spending and

  period of the new infla4on targe4ng mechanism providing

  stable and –  low infla4on (2%) and –  low interest rates,

Background:   They were all but that!   in the long term, low

interest rates were a green light for many: –  the consumers, –  the households, –  the investors, and –  the governments,

to start borrowing excessively with expectation of ever low repay interest rates!

Background:   The more the households

borrowed,   the more they would consume   creating higher demand, and,   the resulting higher GDP output   enabled governments to borrow

and spend even more.

  The low inflation was supported by import of cheaper goods from developing countries, and

  the trade deficit was balanced by government debt being sold to the same, mainly exporting countries of East Asia

  whose foreign reserves rocketed since 2002.

Crisis at The Gate:   Many authors, in particular from

IMF background, argue that   increase in public debt   reduces prospects of growth

mainly due to the pattern of resulting under-investment caused by the investor expectation of higher: –  long-term interest rates, –  future taxation, –  inflation and –  economic volatility

  see e.g. Kumar M.S. and Woo, J 2010: Public Debt and Growth1, IMF Working Paper, July 2010.

Crisis at The Gate:   As few authors show, in some cases increased debt may be beneficial for growth.

  Traum and Yang (2009) show that if increased government debt was used to –  reduce capital gains taxes or –  for business investment,

then further investment can be   attracted (I.e. crowded-in)   instead of being discouraged

(and crowded-out),   leading to increase of GDP

  see: Nora Traum And Shu-Chun S. Yang (2009): Does Government Debt Crowd Out Investment? A Bayesian Dsge Approach;

Crisis and the Bubble Burst: Infla.on mis-‐targe.ng   in spite of the rising inflation in

2003 and 2004,   the federal funds target rate

was lowered even further from 2002 to 2004 (left) and

  the resulting, “real” fed. funds target rate (lower left), i.e. the rfft – π (inflation) was actually around 2.5% below 0 in Q1 of 2004!

  then it rose, from Q2 of 2004, to nearly +3.5% by Q4 of 2006 and

  stayed rather high throughout 2007.

Crisis and the Bubble Burst: Infla.on mis-‐targe.ng

  Few authors showed that lowering of federal funds target rate from –  6.5% in 2000 to a –  mere 1% by mid 2003

may have accelerated both –  the industrial and –  the private housing investment

and the sale of both: –  the prime and –  the sub-prime mortgages

see e.g.: Dokko, J., Doyle, B., Kiley, M. T., Kim, J., Sherlund, S., Sim, J., and Van den Heuvel, S.: Monetary Policy and the Housing Bubble,; Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. 2009


  Whilst US Fed (and Mr B. Bernanke) reject that FED facilitated the housing bubble

  in contrast, J.B.Taylor (2007) indicated that such “too loose” monetary policy during 2003-2004 period probably lead to the extensive housing activity.

  See: Taylor, John B. (2007). Housing and Monetary Policy, NBER Working Paper Series 13682.Cambridge, Mass.: National Bureau of Economic Research, December 2007.

Crisis and the Bubble Burst: Infla.on mis-‐targe.ng   Gordon (2009) also points to

many similarities between 1927-29 and the 2003-06 bubbles, from –  highly leveraged (90%), low

interest loans for stock and housing purposes respectively, to

–  the regulatory failures caused by repeal of Glass-Steagall Act.

  see: Gordon,R. J. (2009). Is Modern Macro or 1978 Era Macro More Relevant to the Understanding of the Current Economic Crisis? Northwestern University, September12, 2009


  They however note:   …“It is widely acknowledged

that the Fed maintained short term interest rates too low for too long in 2003 04, in the sense that any set of parameters on a Taylor Rule type function responding to inflation and the output gap predicts substantially higher short term interest rates during this period than actually occurred… thus indirectly the Fed’s interest rate policies contributed to the housing bubble”

Crisis and the Bubble Burst:

Crisis and the Bubble Burst:   Mishkin (2007) and Jonas and

Mishkin (2005) state that net (core) inflation model is frequently –  more volatile and –  it leads to targets being missed

more than would have been case with the headline inflation.

  See: –  Mishkin, F: Monetary Policy

Strategy, MIT Press, 2007 –  Jonas and Mishkin (2005)

Inflation targeting in Transition Economies, in Bernanke, B. and Woodford, M. Inflation targeting debate, NBER 2005

Crisis and the Bubble Burst:   Quite few articles show how

contagion of sub-prime MBS (mortgage based securities) collapse spread beyond the borders of US.

e.g.:   Steven B. Kamin and Laurie

Pounder DeMarco(2010): How Did a Domestic Housing Slump Turn into a Global Financial Crisis?; Federal Reserve System International Finance Discussion Papers 2010.

  Brender A and Pisani, F.(2010), CEPS, Brussels.

Why the Bubble Burst:   Similarly to the 1929 Great Depression crisis,

  a sudden and sharp monetary tightening

  with target rate rising 6% in period form 2004-2006

  most likely triggered the 2007 bubble burst too.

See:   Bernanke, Ben S. (1983), Non-

Monetary Effects of the Financial Crisis in the Propagation of the Great Depression, American Economic Review,73(3), June 1983, 257-76.

  Bernanke, B. 1995: The Macroeconomics of Great Depression, Journal of Money, Credit and Banking v.27, No. 1 (Feb. 1995) 1-28

Why the Bubble Burst: Debt accelerator   I.e., the 2007 bubble burst was

triggered by a combination of   interest rate increase and   an un-foreseen accelerating

effect of high debt:   the unusually high borrowing   caused by the low rates in the

previous period   had devastating effect on the

disposable income of the borrowers once the rates suddenly rose, and, caused

  a drop of the consumption demand and

  the resulting drop in GDP   and bank bankruptcies

Why the Bubble Burst: Debt accelerator   E.g. a cash and a interest only

mortgage strapped household,   with mortgage 30% of

disposable income   after interest rates doubled,   could not continue repaying

mortgage which   now amounted to 60% - 90%

of their disposable income.   Nor it could spend as usually.   This dual accelerating effect

then lead to –  collapse of demand –  GDP, and –  bank bankruptcies, further

accelerated by many fixed-rate mortgages

How the Bubble Burst accelerated:   than the known mechanisms of

–  financial a(de)ccelerator and –  credit rationing –  animal (hurd) instinct

  were also triggered fuelling the crisis further and,

  CDO & CDS contagion farther.   Bernanke, B, Gertler, M. and

Gildchrist, S. 1999: The Financial Accelerator in a Quantitative Business Cycle Framework, O J. Taylor and M. Woodford, eds. Handbook of Macroeconomics, North Holland, Amsterdam, 2000.

  Stiglitz J.E and Greenwald, B.: Towards a New Paradigm in Monetary Economics, CUP 2003

Possible ra.onale for keeping target rates low :

  Keeping wolfs of Japan-like deflation outside gates   to encourage households’ consumption and growth   Fed unaware of looming inflation in 2003-4 due to

incomplete real-time data,   FED using starting to use core rather than the

headline inflation measure,   Model Insufficiencies   Distortionary political effect of Presidential elections

in 2004 and 2008

Model Insufficiencies   Bernanke, B, Gertler, M. and Gildchrist, S. 1999 as many

other authors use standard linarised Euler equation •  ct= -σrt + E(ct+1)

  but it can not capture the time-variant effect of time variable loans on σ or on E(ct+1) due to RE.

  Also, most commonly used household budget constraint equations such as Smets and Wouters

  accounts for income but it does not account for the loan borrowing effect.

  See: Smets, F. and Wouters, .: Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach, American Ecnomic Revieew, 2007. (model in Appendix document)

Possible ra.onale for keeping target rates low : Distortionary effect of Presidential elections in 2004 and 2008:   Alesina et al(1992) and find   “Our results can be summarized as follows: ….   2) We see some evidence of “political monetary cycles,” that is,

expansionary monetary policy in election years;   3) We also observe indications of “political budget cycles,” or

“loose” fiscal policy prior to elections;   4) Inflation exhibits a post-electoral jump, which could be

explained by either the pre-electoral “loose” monetary and fiscal policies and/or by an opportunistic timing of increases in publicly controlled prices, or indirect taxes.”

see: - Alesina, A. Cohen G. D., Roubini, N. Macroeconomic Policy and Elections in OECD Democracies, Economics & Politics Volume 4, Issue 1, pages 130, March 1992 - Frenzese, R.J. : Electoral and Partisan Manipulation of Public Debt in Developed Democracies, 1956-90, Institute for Social Research, The University of Michigan working paper, May 1999

Conclusions:   Keeping interest rates low despite inflation and targeting rule, and,

  then rising them sharply contributed to the housing market   bubble growing and   its bursting, respectively. Consequently, some form of either

  loan debt/GDP and/or

  housing asset price bubble targe4ng should be included

in

  the stricter followed Taylor rule, or,

  addi4onal FM control mechanism

  in a richer, more complex, mul4ple (heterogeneous) agent models so that bubbles can be contained and managed beNer.

Effects of infla.on targe.ng misfiring on development of housing market bubble

and its burs.ng in 2008 credit crisis

Author: George Perendia, LMBS e-‐mail: [email protected]

Thank you for listening!

George perendia

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