Interest Rate Roundup

Wednesday, January 17, 2007

Fed's Mishkin weighs in on house, asset prices

Lost amid all the other hubbub, Federal Reserve Governor Frederic Mishkin weighed in on the Fed and its view on how to respond to bubbles in asset and home prices.

First, he notes the extraordinary growth in home prices in recent years -- 8 3/4% annually over the past five years. He points out that we haven't just had huge increases in the U.S., but also all over the world, from Australia to Spain to the U.K. to Sweden (Hey wait a minute ... I thought the Fed believed there were just a few areas or localized "froth")

Second, he points out what I've been saying for a long time, notably ...

"Although increases in house price have recently moderated in some countries, they still are very high relative to rents. Furthermore, with the exception of Germany and Japan, the ratios of house prices to disposable income in many countries are greater than what would have been predicted on the basis of their trends"

Third, he went on to ask important questions that should have been asked a couple years ago ...

"Because central banks are in the business of managing total demand in the economy so as to produce desirable outcomes on inflation and employment, monetary policy should accordingly respond to home prices to the extent that these prices are influencing aggregate demand and resource utilization. The issue of how central banks should respond to house price movements is therefore not whether they should respond at all. Rather, the issue is whether they should respond over and above the response called for in terms of objectives to stabilize inflation and employment over the usual policy time horizon. The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy, as they were in Japan in the 1990s, should the monetary authority try to prick, or at least slow the growth of, developing bubbles?"

As I read these first few paragraphs, I couldn't help but wonder: Are we making progress? Is an actual Fed official finally admitting on the record that 1) its own actions are the reason that house prices exploded beyond any measure of fundamental value and 2) that the Fed will do its best to avoid fueling asset bubbles in the future?

Yeah, right! In response to the questions he posed about whether the Fed should do something about ridiculous bouts of asset inflation, Mishkin said quite simply: "I view the answer as no."

He pointed out that while central bankers in England, Sweden, and Europe have either specifically mentioned home prices as a reason for hiking rates, or have indicated a willingness to lean against the asset bubble wind, he doesn't think that makes sense. He claims that:

1) The Fed can't identify a bubble in progress any better than the private market.

2) The Fed CAN effectively restore economic health in the wake of a bust by taking appropriate monetary actions, so there's no need to pre-emptively target an asset bubble. That's especially true in the case of a housing bust, according to Mishkin, because the consequences shouldn't be very painful for financial institutions. He says that's because house prices usually don't fall that much after a boom, because recoveries from foreclosures limit bank losses, and because default rates on residential mortgages typically are low.

3) Higher interest rates may not stem the inflating of an asset bubble ... instead, they could cause it to burst prematurely and more severely than it would if the Fed did nothing.

4) Lastly, he claims that if the Fed started going after asset prices, it would weaken public support for the Fed. That might "cause the public to worry that it is too powerful and has undue influence over all aspects of the economy."

But after claiming that the Fed cannot determine when there are asset bubbles ... and claiming that the Fed should not pre-emptively try to keep those bubbles from getting too big ... Mishkin says the Fed should absolutely step in when there's a bust. Specifically, he said:

"Instead of trying to pre-emptively deal with the bubble--which I have argued is almost impossible to do--a central bank can minimize financial instability by being ready to react quickly to an asset price collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different scenarios to assess how it should respond to an asset price collapse. This is something that we do at the Federal Reserve.

"Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that commercial financial institutions and banking supervisors conduct all the time. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can minimize the damage from a collapse of an asset price bubble without having to judge that a bubble is in progress or predict that it will burst in the near future."

As I see it, the problem with the Fed's "asset prices are not our problem" argument is the asymmetry of the whole thing. The Fed claims it can't identify an asset bubble as it builds ... and that it shouldn't be in the business of deciding whether the current level of asset prices is appropriate when those prices are rising.

But when an asset bubble bursts, and prices start falling, the Fed essentially believes it should swoop in and save the day. It should prevent financial institutions who took on too much risk ... and who helped speculators bid asset prices through the roof ... from failing. And it should work to stabilize asset prices -- in other words, it should substitute its judgment for the market's judgment that those asset values should decline even further.

You can call it the "Greenspan put" ... "Moral Hazard" ... or whatever you want. I just call it flawed monetary policy. It encourages speculators to go nuts and throw a gigantic party in asset market after asset market because A) They know the Fed won't intervene and take the booze away and B) Even if they get behind the wheel, drive drunk, crash into a tree, and go to jail, the Fed will be there to bail them out ... over and over again.


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