Wednesday, November 12, 2014

Monetary Offset applies to Asset Values, too

The conflation of asset prices with inflation has led to very damaging confusion.  Much of the discussion of this point seems to build on the idea that either open market operations (OMO) from the Fed bid up treasury bond prices or that the cash infusion is somehow funneled persistently into asset markets, as opposed to consumption.

While there are some (arguable, in scale, persistence, and effect) ways in which OMO might create short term jumps in some asset prices, is there any theory that lays out how dovish monetary policy could create persistent inflation of asset prices relative to consumption prices?

Here is a graph of household real estate values and mortgage levels, as a proportion of GDP.  Note that, while there was some rise in mortgage levels, relative to incomes, total real estate values were expanding much more quickly in the 2000s.

The next graph shows the leverage of household real estate (mortgages / market values).  Leverage had increased in the late 1980's and early 1990's.  But, this was coincident with declining relative home values.  (I have speculated that these patterns are consistent with the idea that real estate serves as a means of consumption smoothing in economies with high levels of human capital, and that we should have expected the baby boomer demographic to lead to higher mortgage levels in the 1990's, and then higher real estate prices in the 2000's that were mostly in the form of equity gains.)

So, there was no net leveraging during the entire period of the subprime loan buildup.  Leverage didn't create the housing boom.  The sudden rise of leverage was the result of the collapse of asset values.

The next graph shows the YOY change in nominal levels of real estate values, mortgages, and net equity.  Again, we can see here that, for most of the housing boom, real estate market values were rising much faster than mortgage levels were.  So much faster that for much of the bubble, households were gaining about $2 in equity for every dollar of mortgage funding.

Here is a sign of the problems caused by the subprime boom, though.  Initially, because of low interest rates, mortgage debt service remained fairly stable, even though mortgage levels were climbing along with home values.  When short term rates started to rise in 2004, debt service ratios began to climb fairly steeply.  Previously, debt servicing ratios had not been so responsive to short term rate movements.

So, by early 2006 home prices had topped out and mortgage debt service levels had reached the highs of the previous cycle and were steeply rising.  No crisis had come yet, and leverage levels were still where they had been for 10 years.  And, already by this time, the yield curve had inverted.  The Fed Funds Rate would remain higher than the 10 year treasury rate until February 2008 - a full 20 months.

I want to keep all of this in mind as we look at the next graph.  During the housing boom, until 2006, presumably, there was a net increase in aggregate demand as a result of credit creation.  On the other hand, some of these activities reflect household savings.  The balance of these factors would play out through inflation and NGDP.

If loose monetary policy was creating home price increases, we would expect to see something like the late 1970's, where everything is moving together - inflation at 5-10%, currency growing at 10% per year, NGDP growing at 10%+ per year, and houses going up along with everything else.

A target-based monetary authority, whether targeting inflation or NGDP, would automatically offset demand coming from asset price movements.  In the 2000s, NGDP and inflation were both well within their 20 year bands of normal (relatively low) growth levels.  If homes were acting like ATM's, flooding the economy with cash, then why wasn't NGDP high?  If NGDP doesn't look high because it didn't account for the high cost of housing, how can this be the case when mortgage debt servicing was stable until after rates were hiked?  If mortgage debt service was only low because the Fed was artificially pushing down rates for years on end, then why was currency in circulation growing at less than 5% per year?  How does the Fed push down rates without pushing currency into the economy?

In fact, the very low growth in currency in circulation suggests that the Fed was, indeed, offsetting any effects.  They wouldn't have to do it explicitly.  Their inflation target would cause them to do it implicitly.

And, I wonder, maybe this was the problem.  The Fed had only been implicitly offsetting the demand effects of the housing boom.  When their offset became too strong, and home values started to collapse, the offset became explicit.  Now, the consensus was that the collapse had been a long time in coming and was probably something the economy needed to see.  In fact, those high home prices must have been a product of loose policy that was showing up in home values instead of inflation.  Now that the idea was explicit, the Fed simply continued with their explicit policy of not offsetting the demand effects of the housing market.  From February 2007 to September 2008, YOY growth in currency-in-circulation remained under 2.5% while home prices fell by nearly 10%.

But, don't blame the Fed.  How much flack would they have taken if in 2009 inflation was at 4%, homes were up another 20% instead of down, if subprime teaser loans had been reset at low rates, and if bankers were sitting on high profits?  Now, they are largely seen as heroes, and if there is one complaint against them it is that they didn't let the banks suffer enough.  In the counterfactual, where many working class households would still be in their homes, sitting on some home equity, and unemployment may never have topped 7%, would the Fed be seen as heroes?  Or would the country be divided between many on the left complaining that the Fed was feeding inequality by boosting asset prices and many on the right complaining about the coming day of reckoning and malinvestment?  We wouldn't let them explicitly offset the housing bust.

Yet, take out housing, and there is nothing in that data that comes close to implying monetary excess in the 2000s.  And the one thing about housing that is completely outside the historical norm is the devastating collapse of 2007-2012.

Will we always be fighting this deep human tendency to distrust abundance?  This is not a partisan issue, which is why it is such a problem.  It spans the political spectrum.  For some time, speculators (buyers and lenders) were cashing in on an asset boom.  Speculation isn't an admirable way to gain treasure.  We aren't going to purposefully create destruction, of course.  But, if losses have to be taken, well, we kind of had it coming, didn't we?  OWS fans and Austrian business cycle proponents may speak different languages, but they are really part of an ecumenical movement from our shared source of human intuition.  Is there a more universal human intuition than the idea that the gods are serving us our comeuppance?  How do we know it was a bubble?  Well, just look how bad the bust was.

"All asset bubbles come from carnal greed which is in speculators and bankers insatiable" is only a slight paraphrase.

PS. Matt Taibbi at Rolling Stone introduced us to Alayne Fleischmann.
Her decision to go into finance surprised those closest to her, as she had always had more idealistic ambitions. "I helped lead a group that wrote briefs to the Human Rights Chamber for those affected by ethnic cleansing in Bosnia-Herzegovina," she says. "My whole life prior to moving into securities law was human rights work."
But she had student loans to pay off, and so when Wall Street came knocking, that was that.
Clearly, she is not one of them.  And, he notes:
Back in 2006, as a deal manager at the gigantic bank, Fleischmann first witnessed, then tried to stop, what she describes as "massive criminal securities fraud" in the bank's mortgage operations. (emphasis mine)

I don't mention this to cast doubt on Ms. Fleischmann.  I don't think anyone would be surprised to find out that there were a lot of people scrambling to cover their backsides, frequently in unscrupulous ways, and that the large banks have tentacles in the regulatory agencies.  That timing is interesting, though.  When she first witnessed securities fraud, the Fed Funds rate was solidly at 5.25% and 10 year treasuries were bobbling around 4.75%.


  1. Kevin, I left this comment over at TMI,

    I’d focus on breaking that period up as follows:

    2004:4 to 2005:4 6.5%
    2005:4 to 2006:4 5.1%
    2006:4 to 2007:4 4.4%

    You could argue the NGDP growth is slowing, but under level targeting that might be appropriate. I don’t see a significant policy change from a 5% level target.


    2007:4 to 2008:2 1.75% annual rate (mild recession.)
    2008:2 to 2008:4 minus 3.5% (deep recession)

    Nick, It would not take very long to catch up to a 2% inflation track, so I think it would be credible. But obviously they have to move the policy instruments to do so.

    1. Scott, I guess the question is how much lag there is between a monetary adjustment and an NGDP reaction. The Fed uses a 1 year lag on the yield curve indicator, which is the signal I reference in my blog post.

      You make a good point that the moderate declines in 2006 could be reasonable trend reversion. But that's a sign of monetary policy in 2004 and 2005, isn't it? When would you place the monetary adjustments that relate to the increasingly sharp NGDP declines of late 2007 to late 2008?