Tuesday, October 29, 2013

Real Rates vs. Inflation regarding Housing Prices

Tyler Cowen linked to two pieces on asset prices from Bordo and Landon-Lane looking at asset prices in relation to monetary policy, which got me thinking more about home prices.  Here is a simple chart I put together to help visualize the relationship.

The pieces linked by Tyler seem misguided to me.  It looks to me like the core idea is a tautology - that the market value of assets move inversely to interest rates.  Then, they attribute the movements in those interest rates to monetary policy, with low rates reflecting loose policy and vice versa.

This seems dangerous to me.  Durable assets should have a strong inverse reaction to real long term interest rates.  But, these rates are not dependably related to monetary policy.  To the extent that durable assets act as inflation hedges, a loose monetary policy could reduce their real value by changing the skew of the inflation risk.  And, as I have pointed out with the housing market, inflation can reduce home prices by decreasing demand through high nominal mortgage rates.

The dangerous part is that if rates are low, not because of short term central bank maneuvers, but because of a lack of investment demand or some other structural economic problem, then calls for central banks to tighten monetary policy as a reaction to low rates/high asset prices, would be needlessly damaging.  In fact, it appears as though this is what happened in 2007-2008.

The lowest inflation and NGDP growth rates in the 1970's were higher than the peaks in the 2000's.  Isn't it clear that the low real rates and high asset prices, at least in the 2000's, are driven by something other than loose monetary policy?

1 comment:

  1. Exactly right. This should be obvious--famously it was to Milton Friedman--but, in my experience, almost no one works with this assumption in mind.