Monetary Policy Challenges Posed by Asset Price Booms

Stephen G. Cecchetti

Rosenberg Professor of Global Finance

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Outline

Risks Posed by Asset Price Booms Policy Options Current State of the U.S. Economy

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“A central bank seeking to maximize its probability of achieving its goals is driven, I believe, to a risk-management approach to policy. By this I mean that policymakers need to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path.”

Alan Greenspan, August 2003.

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A Risk Management Approach

Control the probability of catastrophes. Financial Institution:

Reduce risk of substantial monetary loss. Primary objective of monetary policy:

Make sure nothing really bad happens. For a Central Bank:

Control output & price deviations from trend.

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Asset Price Booms and Busts

Concern is primarily over catastrophes

Natural to study the tail outcomes

Conditional on seeing equity or housing prices rise by X%, what is the worst that can happen in the next year, in two years, in three?

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Risks Created by Bubbles

Look at some data:

Real Equity: 27 countries

Real Housing: 17 countries

Deviations of GDP from full-sample HP-filter.

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Risks Created by Bubbles: Some estimates Mean:

Real equity prices 20% above trend4 quarters later, output gap is +0.85

Real housing prices 10% above trend 12 quarters later, output gap is -1.42 12 quarters later, price gap is +1.04

Volatility Real housing prices 10% above trend

12 quarters later, output gap volatility is +5%

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Risks Created by Bubbles: Some estimates Worst Outcomes

(expected loss in lowest quartile) Equity: 20% boom lowers output gap

tail 12 quarters later by 0.85 Housing: 10% boom lowers output gap

tail 12 quarters later by 0.59

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Risks Created By Asset Booms

Levels: Equity & Housing Output & Prices rise 4Q Housing Output & Price declines 8-12Q+

Volatility: No impact on price level volatility Housing booms increase GDP volatility

Expected Tail Loss Increase the probability of BAD events!

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Equity vs. Housing

Equity is typically 50% of GDP Housing is closer to 100% of GDP Equity holding is concentrated Housing bubbles increase bad outcomes

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Equity vs. Housing

Should we care about equity at all? Median capitalization <40% of GDP Interquartile range is 18% to 70% of GDP.

Housing wealth effect tends to be large.

Should there be any aggregate housing wealth effect?

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Policy Options

1. Lean against the bubble

2. React to changes in inflation forecasts

3. Lean against the bust

4. Include housing prices target index.

5. Look for regulatory solutions.

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Are Interest Rates the Right Instrument?

Interest rates affect output & prices with a lag.

Lags mean reducing interest rates in anticipation of the bubble bursting.

But lowering interest rates reduces the probability the bubble will burst.

Is it really possible to get the time right?

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Housing prices price indices?

Is this the right thing to do? Central bank objective:

Stabilize the price of lifetime consumption. Analysis suggests substantial weight. Acquisition cost approach seems justified.

(Note: No such evidence for stock prices.)

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0

0.5

1

1.5

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2.5

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3.5

4

4.5

5

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Core PCE Inflation Core PCE w/ OFHEO

Putting Home Sale Prices in the Core PCE Price Index

2000 -2005: 3/4 percentage points higher!

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Regulatory Solutions

Prudential regulation ensures that financial intermediaries remain well capitalized

What about households?Are there times when lenders should be forced to restrict housing finance?

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Current State of the U.S. Economy

Federal Reserve Actions Short Term Objectives Long Term Objectives

What’s Next?

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Federal Reserve’s Short-Term Objectives

“Do financial institutions and markets have sufficient funds to carry out their daily business?”

Ensure markets remain liquid

“Do market determined risk spreads accurately reflect current uncertainties in economic fundamentals?”

Encourage rational valuation of collateral

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Federal Reserve’s Long-Term Objectives“Are current financial conditions appropriate to

attain medium-term macroeconomic stabilization objectives?”

Does the September rate cut jeopardize Medium term inflation objectives? Maximum sustainable growth?

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Inflation:Trend is Falling

0

0.5

1

1.5

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2.5

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3.5

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4.5

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Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

12-M

on

th P

erce

nt

Ch

ang

e

Headline CPI CPI ex F&E Trimmed Mean

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Real Growth: What is the trend?

-4

-2

0

2

4

6

8

10Ja

n-61

Jan-

63

Jan-

65

Jan-

67

Jan-

69

Jan-

71

Jan-

73

Jan-

75

Jan-

77

Jan-

79

Jan-

81

Jan-

83

Jan-

85

Jan-

87

Jan-

89

Jan-

91

Jan-

93

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

1960-724.2%

1973-943.0%

1995-20003.9%

Simple Taylor Rule:

0

1

2

3

4

5

6

7

8

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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Per

cen

t

Rate Implied by the Taylor Rule FOMC Target

2%

What is neutral?

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Structural Questions

1. Do policymakers have the tools for the job?

What are the central bank’s instruments? Target overnight rate Lending rate Deposit rate Collateral in Open Market Operations Term in Lending Collateral in Lending

What should be the extent of public disclosure?

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Structural Questions

2. How can we mitigate information problems that plague financial arrangements?

Collateral, Net Worth Ratings agencies Data collection and disclosure Exchange-trading and the Clearinghouse

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Supplementary Tables

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Risks Created By Bubbles

How do booms change theMean & Volatility

of output and price-level gaps?

Mean: xit = a + b dit-k() + it

xit= output or price-level gap dit-k() = 1 if k periods earlier filtered asset price exceeded threshold

Volatility: (xit )2= a’ + b’ dit-k() + it

Table 1: Impact of Asset Price Booms on the Levels Level of the Output Gap Price Level Lag of Asset Price (k) Lag of Asset Price (k)

EQUITY Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.03 0.01 0.00 Data -0.07 0.00 0.04 1.00 0.96 0.25 0.03 0.50 0.92 4 1.05 0.28 -0.21 4 -0.61 0.10 0.99 1.00 0.99 0.10 0.30 0.58 0.94

12 0.92 0.32 -0.15 12 0.04 0.54 1.32 1.00 0.99 0.23 0.51 0.71 0.92

20 0.85 0.16 -0.07 20 -0.65 0.71 1.58 1.00 0.81 0.38 0.39 0.69 0.88

HOUSING Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.06 -0.04 -0.09 Data 0.04 0.08 0.07 1.00 0.00 0.00 0.99 1.00 1.00 2 0.46 -0.53 -0.92 2 0.62 0.96 0.70 1.00 0.00 0.00 1.00 1.00 1.00 6 0.85 -0.50 -1.28 6 0.55 1.14 0.95 1.00 0.01 0.00 0.98 1.00 1.00

10 1.10 -0.42 -1.42 10 0.52 1.19 1.04 1.00 0.12 0.00 0.92 1.00 1.00

10% housing price deviation output gap average -1.42, 12 quarters later

Table 1: Impact of Asset Price Booms on the Levels Level of the Output Gap Price Level Lag of Asset Price (k) Lag of Asset Price (k)

EQUITY Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.03 0.01 0.00 Data -0.07 0.00 0.04 1.00 0.96 0.25 0.03 0.50 0.92 4 1.05 0.28 -0.21 4 -0.61 0.10 0.99 1.00 0.99 0.10 0.30 0.58 0.94

12 0.92 0.32 -0.15 12 0.04 0.54 1.32 1.00 0.99 0.23 0.51 0.71 0.92

20 0.85 0.16 -0.07 20 -0.65 0.71 1.58 1.00 0.81 0.38 0.39 0.69 0.88

HOUSING Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.06 -0.04 -0.09 Data 0.04 0.08 0.07 1.00 0.00 0.00 0.99 1.00 1.00 2 0.46 -0.53 -0.92 2 0.62 0.96 0.70 1.00 0.00 0.00 1.00 1.00 1.00 6 0.85 -0.50 -1.28 6 0.55 1.14 0.95 1.00 0.01 0.00 0.98 1.00 1.00

10 1.10 -0.42 -1.42 10 0.52 1.19 1.04 1.00 0.12 0.00 0.92 1.00 1.00

Table 2: Impact of Asset Price Booms on Volatility Volatility of the Output Gap Price Level Volatility Lag of Asset Price (k) Lag of Asset Price (k)

EQUITY Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.00 0.01 0.00 Data 0.00 0.00 0.00 0.14 0.07 0.30 0.38 0.08 0.18 4 0.03 0.33 0.24 4 0.00 0.00 0.00 0.43 0.08 0.14 0.15 0.54 0.46

12 0.15 0.05 0.19 12 0.00 0.00 0.00 0.26 0.41 0.15 0.13 0.13 0.12

20 0.39 0.20 0.11 20 0.00 0.00 0.01 0.12 0.27 0.34 0.16 0.11 0.06

HOUSING Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.22 0.12 0.05 Data -0.02 0.00 0.02 0.04 0.18 0.35 0.64 0.53 0.34 2 2.46 2.84 1.43 2 -0.09 0.50 0.66 0.02 0.01 0.12 0.57 0.12 0.17 6 4.39 4.75 1.93 6 0.55 0.60 0.87 0.01 0.01 0.12 0.18 0.10 0.16

10 5.48 2.46 5.28 10 0.88 0.38 0.80 0.04 0.07 0.04 0.16 0.23 0.19

10% housing price deviation volatility of output gap rises by 5.28% 12 quarters later

Table 2: Impact of Asset Price Booms on Volatility Volatility of the Output Gap Price Level Volatility Lag of Asset Price (k) Lag of Asset Price (k)

EQUITY Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.00 0.01 0.00 Data 0.00 0.00 0.00 0.14 0.07 0.30 0.38 0.08 0.18 4 0.03 0.33 0.24 4 0.00 0.00 0.00 0.43 0.08 0.14 0.15 0.54 0.46

12 0.15 0.05 0.19 12 0.00 0.00 0.00 0.26 0.41 0.15 0.13 0.13 0.12

20 0.39 0.20 0.11 20 0.00 0.00 0.01 0.12 0.27 0.34 0.16 0.11 0.06

HOUSING Threshold

() 4 8 12

Threshold ()

4 8 12

Data 0.22 0.12 0.05 Data -0.02 0.00 0.02 0.04 0.18 0.35 0.64 0.53 0.34 2 2.46 2.84 1.43 2 -0.09 0.50 0.66 0.02 0.01 0.12 0.57 0.12 0.17 6 4.39 4.75 1.93 6 0.55 0.60 0.87 0.01 0.01 0.12 0.18 0.10 0.16

10 5.48 2.46 5.28 10 0.88 0.38 0.80 0.04 0.07 0.04 0.16 0.23 0.19

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Expected Lower Tail Loss

Expected Value conditional on being lower tail

xit = a + b0 dit-k() +b1tail()it+b3 dit-k()x tail()it +it xit= output or price-level gap

dit-k() = 1 if k periods earlier filtered asset price exceeded threshold

tail()it = 1 if xit is in the -percent tail

b3 estimate of impact of asset price boom of size

on expected tail loss in lowest -percent of the dist.

Table 3: Impact of Asset Price Booms on the Lowest Quartile Output Gap Price Level Gap Lag of Asset Price (k) Lag of Asset Price (k)

EQUITY Threshold

() 4 8 12

Threshold ()

4 8 12

Data -0.03 -0.02 0.01 Data -0.26 -0.21 0.03 0.10 0.12 0.63 0.02 0.06 0.59 4 -3.81 -2.50 -1.87 4 -14.05 -16.12 -13.88 0.00 0.00 0.00 0.00 0.00 0.00

12 -4.63 -1.75 -1.70 12 -16.38 -19.20 -16.35 0.00 0.01 0.01 0.00 0.00 0.00

20 -5.37 -2.05 -0.85 20 -18.06 -20.73 -17.36 0.00 0.02 0.05 0.00 0.00 0.00

HOUSING Threshold

() 4 8 12

Threshold ()

4 8 12

Data -0.01 -0.03 -0.01 Data 0.06 0.10 0.09 0.35 0.11 0.35 0.67 0.84 0.76 2 -1.53 -1.08 -0.69 2 -2.47 -4.03 -5.01 0.00 0.00 0.00 0.00 0.00 0.01 6 -1.42 -1.15 -0.28 6 -2.89 -4.83 -9.22 0.00 0.00 0.18 0.00 0.00 0.00

10 -1.16 -0.34 -0.59 10 -3.28 -3.91 -12.29 0.00 0.12 0.08 0.00 0.00 0.00

20% equity price deviation ETL in lowest quartile of output gap rises by -0.85 12 quarters later

Table 3: Impact of Asset Price Booms on the Lowest Quartile Output Gap Price Level Gap Lag of Asset Price (k) Lag of Asset Price (k)

EQUITY Threshold

() 4 8 12

Threshold ()

4 8 12

Data -0.03 -0.02 0.01 Data -0.26 -0.21 0.03 0.10 0.12 0.63 0.02 0.06 0.59 4 -3.81 -2.50 -1.87 4 -14.05 -16.12 -13.88 0.00 0.00 0.00 0.00 0.00 0.00

12 -4.63 -1.75 -1.70 12 -16.38 -19.20 -16.35 0.00 0.01 0.01 0.00 0.00 0.00

20 -5.37 -2.05 -0.85 20 -18.06 -20.73 -17.36 0.00 0.02 0.05 0.00 0.00 0.00

HOUSING Threshold

() 4 8 12

Threshold ()

4 8 12

Data -0.01 -0.03 -0.01 Data 0.06 0.10 0.09 0.35 0.11 0.35 0.67 0.84 0.76 2 -1.53 -1.08 -0.69 2 -2.47 -4.03 -5.01 0.00 0.00 0.00 0.00 0.00 0.01 6 -1.42 -1.15 -0.28 6 -2.89 -4.83 -9.22 0.00 0.00 0.18 0.00 0.00 0.00

10 -1.16 -0.34 -0.59 10 -3.28 -3.91 -12.29 0.00 0.12 0.08 0.00 0.00 0.00