Monday, March 4, 2013

Bernanke, Bankers, Bubbles

In 1999, at the height of the dot-com bubble, Ben Bernanke and Mark Gertler argued emphatically against central banks responding to movements in asset prices.  Monetary policy could react to the macroeconomic consequences of asset price movements, but not to asset prices themselves. In other words, monetary policymakers should not raise interest rates solely to address a potential bubble.

After the dot-com bubble burst, they held firm in their opinion in a 2001 paper titled "Should Central Banks Respond to Movements in Asset Prices?" Their answer to the title question is a firm no. They build and simulate a model of the economy that includes both technology shocks and "stock price bubble" shocks and find that "an aggressive inflation-targeting rule stabilizes both output and inflation when asset prices are volatile, whether the volatility is due to bubbles or to technological shocks; and that, given an aggressive response to inflation, there is no significant additional benefit to responding to asset prices."

The housing bubble prompted a number of challenges to the Bernanke-Gertler dictum. A fairly common view is that expansionary monetary policy contributed to the housing bubble. Dean Baker and John Taylor have both argued that the housing bubble was caused by the Fed keeping interest rates too low for too long. (In 2001 the Federal Funds Target rate was lowered from 6.5 to 1.75 percent. In 2003 it was lowered to 1 percent and held there for a year.) Bernanke counters that increased use of variable-rate and interest-only mortgages and the decline of underwriting standards were more to blame than low interest rates.

Now, interest rates are again very low, and have been for quite some time. Challenges to the Bernanke-Gertler view are more vociferous than ever, and come not only from John Taylor but also from Chairman Bernanke's committee members and his contemporaries at other central banks. Fed Governor James Bullard, for example, says that "maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years.” Kansas City Fed President Esther George and Fed Governor Jeremy Stein express similar views that the Fed should use its control of interest rates to do something about "overheating." However, Fed Vice Chairwoman Janet Yellen shares Bernanke's view that the benefits of accomodative monetary policy at this point outweigh the risks of any potential financial overheating.

When Bernanke wrote his 1999 and 2001 papers with Gertler, he was a professor at Princeton University. Another Princeton professor, Lars Svensson, is the Deputy Governor of the Swedish Riksbank. At the Riksbank last month, Governor Stefan Ingves warned that low interest rates are driving up household debt. But Svensson is a strong proponent of his former colleague's views. At the February Rikbank meeting, he argued against the committee's concerns that low interest rates could be leading to financial instability. He cites a 2012 paper by Kenneth Kuttner called "Low Interest Rates and Housing Bubbles: Still no Smoking Gun," whose title summarizes its conclusion.  In particular, Kuttner estimates that a 25 basis point expansionary monetary policy shock raises house prices by about 0.3% to 0.9%, which is "too small to explain the previous decade's real estate boom in the U.S. and elsewhere... Credit conditions, broadly defined, may play a larger role in house price booms than interest rates per se. In market-oriented financial systems, like that of the U.S., a loosening of credit conditions plausibly resulted from financial innovation, such as securitization, and a relaxation of lending standards."

Svensson's long list of publications and speeches reveals a longstanding interest in monetary policy and financial stability, with views consistently in accord with Bernanke's. In a 2011 lecture called "Central-Banking Challenges for the Riksbank: Monetary Policy, Financial-Stability Policy, and Asset Management" Svensson notes:
"Monetary policy and financial-stability policy are distinct policies, with different objectives, different instruments, and different public authorities having responsibility for them... Monetary policy should be conducted taking the conduct of financial-stability policy into account, and vice-versa. But they should not be confused with one another. Confusion risks leading to a poorer outcome for both policies and makes it more difficult to hold the policymakers accountable."
One of the most interesting blog posts I have read on this topic is from Miles Kimball, who writes that people taking on more risk as a result of low interest rates is "a genuine cost to the Fed stimulating the economy with low interest rates. But— especially once we figure out the details—it has much bigger implications for financial regulation than for monetary policy...Regulation has serious costs, but so does tight monetary policy in the current environment." This seems to be the view of Bernanke, Yellen, and Svensson, but is still far from a settled issue among the world's monetary policymakers.

10 comments:

  1. I'll make sure to read up on Miles Kimball's writing. I do not know whether he touches upon the following question or not, but here goes: how about the trade-offs faced by a central bank when regulatory authorities refuse to "do their jobs" (lower LTV-ceilings, forced amortisation, hiked risk-weights, reduced deductibility of mortgage costs, ...).

    Parts of the Riksbank's rate-setting majority are mightily frustrated with the lack of action from other authorities. If house prices / household lending continues to rise, AND the Riksbank manages to somewhat normalize rates in say five years, some truly tough times will be faced by Swedish households, unless something is done by other authorities such as Sweden's FSA.

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  3. regailh 545The debate about whether central banks should as a first or second best policy target asset prices is not well joined by consideration of what the alternative policy is: interest rate targeting? NGDP targeting? Exchage rate stability? Are we discussing the optimal weights in a central bank reaction function?

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  4. To Unknown, in the Bernanke Gertler papers the alternative is inflation targeting. That is an interesting question whether targeting asset prices would be more effective if it went along with some other regime like NGDP targeting. Insofar as asset prices affect nominal GDP, NGDP targeting might indirectly entail more asset price targeting.

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  5. I believe the Bloomberg article gives an inaccurate impression of Dean Baker's position. First he probably disagrees with most of what Taylor has to say.

    He agree with other liberals about most things but tends to emphasize the housing bubble as a central focus rather than the financial crisis/bank run. The problem is that the demand supplied by the bubble is gone. See today:

    http://www.cepr.net/index.php/blogs/beat-the-press/the-fed-is-still-way-out-to-lunch-on-financial-bubbles

    As I understand it Baker did not want the Fed to keep interest rates low as Taylor argues. He has said that Greenspan could have simply announced every day that there's a dangerous bubble in the housing market and talked it down. The Fed denied its existence.

    In his new book, Alan Blinder also places focus on the "bond bubble" in MBS. This hit the European periphery as well seeing as Fed interest rate policy wasn't causing a housing bubble in Europe. I've found Taylor to be wrong on many important things. Baker is usually right. Again, Stein was another unforced error by Obama.

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  6. Peter, thanks for the info and the link.
    I got a free signed copy of Blinder's book at the AEA conference. I definitely need to read it!

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  7. It seems like Kutter is operating from a pretty poor model of bubbles. He thinks the only way for a bubble to exist is for the price to be higher than warranted by the given interest rate.

    "Consequently, the observation that house prices rise when interests rates fall
    is not by itself evidence that low interest rates cause bubbles. To make this case, one would have
    to argue house prices tend to overreact to interest rate reductions, i.e., that appreciations are larger
    than warranted by fundamentals."

    Overconstruction does not seem to be part of his idea, nor does valuation by cash flows vs. replacement cost. These are just two possible ways in which housing could be in a bubble which is different than his model.

    Housing is such a bulky transaction, and takes a long time to build. it's an expensive transaction, and highly dependent on the interest rate at the time.

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