Those Low Rates
Via (what else?) Alea’s Twitter feed, John Taylor defends himself against Ben Bernanke:
“The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust,” Taylor, a Stanford University economist, said in an interview today in Atlanta.
It’s not actually that they’re not saying the same thing. Bernanke argued (and I agreed) that low rates did not cause the housing bubble. We have had low rates without producing housing bubbles before. (Other asset bubbles are another question.) Indeed, the last lasting housing bubble peaked just as the Federal Funds rate did:
More accurately (and also via ATF), Caroline Baum takes Bernanke to task for sleight-of-hand:
For example, Bernanke takes great pains to rebut criticism that the funds rate was well below where the Taylor Rule…suggested it should be following the 2001 recession. The Taylor Rule uses actual inflation versus target inflation and actual gross domestic product versus potential GDP to determine the appropriate level of the funds rate.
Substitute forecast inflation for actual inflation, and the personal consumption expenditures price index for the consumer price index, and — voila! — monetary policy looks far less accommodating, Bernanke said.
It’s always easier to start with a desired conclusion and retrofit a model or equation to prove it.
Ouch. Is it a great day when the journalist is making more sense about the economist’s work than another economist is?
But more to the point, the argument that rates were kept unnaturally low from ca. 2002 through ca. 2005 depends very much on the idea that the Fed does not have two jobs. (Once again, h/t to Dean Baker.)
The other half below the break
As Baker notes at the link above, “the dual mandate [of the Fed] is full employment (defined as 4.0 percent unemployment) and price stability.”
Let’s be generous. I’ve plotted the Civilian Employment/Population Ratio and the Official Unemployment Rate below. The blue line at 4.5 applies only to the Unemployment Rate (red line). (I didn’t plot it at 4.0 because that would be cruel.)
So what we have is a situation where (1) the Employment/Population Ratio by the end of 2006 is barely back near the level it was at the end of the recession of 2001 and (2) it is only near the end of 2006 that the Official Unemployment Rates approaches the official target rate (which it hadn’t seen since before the 2001 recession).
It seems apparent that Taylor’s “Rule” (which considers inflation and GDP, but not employment per se) is not compatible with official Fed mandates. In such a context, Caroline Baum’s “gotcha” is more a case of her using inappropriate variables—and Bernanke substituting a more appropriate model, given the Fed’s mandates—than it is a case of Bernanke “retrofitting.”
No wonder John Taylor says we should worry about inflation; in his world, we never have to worry about unemployment, so long as there are enough bubbles to inflate GDP.
Low rates did not cause the bubble, low rates enabled the bubble in real estate (there is a difference). Market participants had to behaviorly take advantge of those low rates, and they did in droves. But my belief at this point, is that the bubble was largely caused by people who were willing to pay more and more for an owned home as compared to a rented home.
The biggest thing to remember is that buying a house with borrowed money is a highly leveraged deal, and it does not take a big drop in value to cause major headaches. It also cut off the engine of econmoic growth during teh Bush years which was the HELOC effect.
Ken:
If one squints really hard, one can begin to imagine that Unemployment Rate is 10% when Participation Rate is where it should be or the same as what it was at the end of 2001. If such was the case, this would be an entirely different labor market with relief in the near term.
“Substitute forecast inflation for actual inflation, and the personal consumption expenditures price index for the consumer price index, and — voila! — monetary policy looks far less accommodating, Bernanke said.
“It’s always easier to start with a desired conclusion and retrofit a model or equation to prove it.”
This is what earns praise? The author is either ignorant of pretty standard Fed views, or wants readers to be ignorant of standard Fed views. The Fed has long favored the PCE deflator over CPI as an inflation measure and has long operated with an eye to forecasts. You know, all that business about using reported inflation to run policy being like driving a car by looking in the rearview mirror?
If it were true that Bernanke had dug up convenient inputs to prove his point, the criticism would be legit. Bernanke dug up exactlly what the Fed has been doing for years and years, and has said publically that it has been doing, to prove his point. It is evidence of ignorance of dishonesty to say otherwise.
Oh, and let’s not get all hung up on Taylor’s original formulation. Yes, everybody was really impressed with it what he he showed how well it describes central bank behavior. And, being so impressed, the monetary policy world set about finding new twists and refinements, in order to make it work even better, and to help set policy, and not just describe it. Using inflation forecasts instead of reported inflation is the very first step in making Taylor’s rule useful for polcy making.
Ken,
I would add a few otehr things that caused the housing bubble (along with the low rates).
1) Change in how capital gains on the sale of the house were handled. Flipping every two years suddenly became profitable.
2) After the dot-com implosion all that liquidity had to go somewhere – it looks like it ended up in housing.
3) Changes in banking rules (maybe just policies?) that allowed banks to bundle mortgages and sell the off to higher bidders – thus insulating them from risk and makinig big bucks.
4) Bubble mania/internet. “Everyone” was doing it and making money hand over fist. I read somewhere that in 2006 something like 1 in 20 Californians had a real estate license or something weird like that. Heck I remember one of the bubble sites way back had a list of all the ex-strippers now posing as real estate agents (it was very funny – wish I could find it again).
And it was very easy to see where the mania was coming from. I sold in NoVA in 2000 when I transferred from the Pentagon. My house sold in one day with a bidding war well over my asking price. That info quickly gets around teh neighborhood – now multiply by thousands and you get teh mani (plus the 5 losing bidders now need to find a home and will bid harder next tim)
YMMV
Islam will change