Effects	
  of	
  infla.on	
  targe.ng	
  misfiring	
  on	
  
development	
  of	
  housing	
  market	
  bubble	
  
and	
  its	...
Background:	
  
  The	
  so	
  called	
  "years	
  of	
  
great	
  modera.on",	
  the	
  
years	
  of	
  rela4vely	
  sta...
Background:	
  
  They were all but that!
  in the long term, low
interest rates were a
green light for many:
–  the con...
Background:	
  
  The more the households
borrowed,
  the more they would consume
  creating higher demand, and,
  the...
Crisis	
  at	
  The	
  Gate:	
  
  Many authors, in particular from
IMF background, argue that
  increase in public debt...
Crisis	
  at	
  The	
  Gate:	
     As few authors show, in some
cases increased debt may be
beneficial for growth.
  Tra...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  Infla.on	
  mis-­‐targe.ng	
  
  in spite of the rising inflation in
2003 and ...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  Infla.on	
  mis-­‐targe.ng	
  
  Few authors showed that
lowering of federal f...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  Infla.on	
  mis-­‐targe.ng	
  
  Whilst US Fed (and Mr B.
Bernanke) reject tha...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  Infla.on	
  mis-­‐targe.ng	
  
  Gordon (2009) also points to
many similaritie...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  Infla.on	
  mis-­‐targe.ng	
  
  They however note:
  …“It is widely acknowle...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  
  Mishkin (2007) and Jonas and
Mishkin (2005) state that net
(core) inflatio...
Crisis	
  and	
  the	
  Bubble	
  Burst:	
  
  Quite few articles show how
contagion of sub-prime MBS
(mortgage based sec...
Why	
  the	
  Bubble	
  Burst:	
     Similarly to the 1929 Great
Depression crisis,
  a sudden and sharp monetary
tighte...
Why	
  the	
  Bubble	
  Burst:	
  Debt	
  accelerator	
  
  I.e., the 2007 bubble burst was
triggered by a combination of...
Why	
  the	
  Bubble	
  Burst:	
  Debt	
  accelerator	
  	
  
  E.g. a cash and a interest only
mortgage strapped househo...
How	
  the	
  Bubble	
  Burst	
  accelerated:	
  
  than the known mechanisms of
–  financial a(de)ccelerator and
–  cred...
Possible	
  ra.onale	
  for	
  keeping	
  target	
  rates	
  low	
  :	
  
  Keeping wolfs of Japan-like deflation outside...
Model	
  Insufficiencies	
  
  Bernanke, B, Gertler, M. and Gildchrist, S. 1999 as many
other authors use standard linarise...
Possible	
  ra.onale	
  for	
  keeping	
  target	
  rates	
  low	
  :	
  
Distortionary effect of Presidential elections i...
Conclusions:	
     Keeping interest rates low
despite inflation and targeting
rule, and,
  then rising them sharply
cont...
Effects	
  of	
  infla.on	
  targe.ng	
  misfiring	
  on	
  
development	
  of	
  housing	
  market	
  bubble	
  
and	
  its	...
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George perendia

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George perendia

  1. 1. Effects  of  infla.on  targe.ng  misfiring  on   development  of  housing  market  bubble   and  its  burs.ng  in  2008  credit  crisis   Author:   George  Perendia,  LMBS   e-­‐mail:  george@perendia.orangehome.co.uk  
  2. 2. Background:     The  so  called  "years  of   great  modera.on",  the   years  of  rela4vely  stable   and  low  infla4on  since   early  1980,       a  period  of  reduc4on  in   government  spending  and       period  of  the  new  infla4on   targe4ng  mechanism   providing     stable  and     –  low  infla4on  (2%)  and     –  low  interest  rates,    
  3. 3. Background:     They were all but that!   in the long term, low interest rates were a green light for many: –  the consumers, –  the households, –  the investors, and –  the governments, to start borrowing excessively with expectation of ever low repay interest rates!
  4. 4. Background:     The more the households borrowed,   the more they would consume   creating higher demand, and,   the resulting higher GDP output   enabled governments to borrow and spend even more.   The low inflation was supported by import of cheaper goods from developing countries, and   the trade deficit was balanced by government debt being sold to the same, mainly exporting countries of East Asia   whose foreign reserves rocketed since 2002.
  5. 5. Crisis  at  The  Gate:     Many authors, in particular from IMF background, argue that   increase in public debt   reduces prospects of growth mainly due to the pattern of resulting under-investment caused by the investor expectation of higher: –  long-term interest rates, –  future taxation, –  inflation and –  economic volatility   see e.g. Kumar M.S. and Woo, J 2010: Public Debt and Growth1, IMF Working Paper, July 2010.
  6. 6. Crisis  at  The  Gate:     As few authors show, in some cases increased debt may be beneficial for growth.   Traum and Yang (2009) show that if increased government debt was used to –  reduce capital gains taxes or –  for business investment, then further investment can be   attracted (I.e. crowded-in)   instead of being discouraged (and crowded-out),   leading to increase of GDP   see: Nora Traum And Shu-Chun S. Yang (2009): Does Government Debt Crowd Out Investment? A Bayesian Dsge Approach;
  7. 7. Crisis  and  the  Bubble  Burst:  Infla.on  mis-­‐targe.ng     in spite of the rising inflation in 2003 and 2004,   the federal funds target rate was lowered even further from 2002 to 2004 (left) and   the resulting, “real” fed. funds target rate (lower left), i.e. the rfft – π (inflation) was actually around 2.5% below 0 in Q1 of 2004!   then it rose, from Q2 of 2004, to nearly +3.5% by Q4 of 2006 and   stayed rather high throughout 2007.
  8. 8. Crisis  and  the  Bubble  Burst:  Infla.on  mis-­‐targe.ng     Few authors showed that lowering of federal funds target rate from –  6.5% in 2000 to a –  mere 1% by mid 2003 may have accelerated both –  the industrial and –  the private housing investment and the sale of both: –  the prime and –  the sub-prime mortgages see e.g.: Dokko, J., Doyle, B., Kiley, M. T., Kim, J., Sherlund, S., Sim, J., and Van den Heuvel, S.: Monetary Policy and the Housing Bubble,; Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. 2009
  9. 9. Crisis  and  the  Bubble  Burst:  Infla.on  mis-­‐targe.ng     Whilst US Fed (and Mr B. Bernanke) reject that FED facilitated the housing bubble   in contrast, J.B.Taylor (2007) indicated that such “too loose” monetary policy during 2003-2004 period probably lead to the extensive housing activity.   See: Taylor, John B. (2007). Housing and Monetary Policy, NBER Working Paper Series 13682.Cambridge, Mass.: National Bureau of Economic Research, December 2007.
  10. 10. Crisis  and  the  Bubble  Burst:  Infla.on  mis-­‐targe.ng     Gordon (2009) also points to many similarities between 1927-29 and the 2003-06 bubbles, from –  highly leveraged (90%), low interest loans for stock and housing purposes respectively, to –  the regulatory failures caused by repeal of Glass-Steagall Act.   see: Gordon,R. J. (2009). Is Modern Macro or 1978 Era Macro More Relevant to the Understanding of the Current Economic Crisis? Northwestern University, September12, 2009
  11. 11. Crisis  and  the  Bubble  Burst:  Infla.on  mis-­‐targe.ng     They however note:   …“It is widely acknowledged that the Fed maintained short term interest rates too low for too long in 2003 04, in the sense that any set of parameters on a Taylor Rule type function responding to inflation and the output gap predicts substantially higher short term interest rates during this period than actually occurred… thus indirectly the Fed’s interest rate policies contributed to the housing bubble”
  12. 12. Crisis  and  the  Bubble  Burst:  
  13. 13. Crisis  and  the  Bubble  Burst:     Mishkin (2007) and Jonas and Mishkin (2005) state that net (core) inflation model is frequently –  more volatile and –  it leads to targets being missed more than would have been case with the headline inflation.   See: –  Mishkin, F: Monetary Policy Strategy, MIT Press, 2007 –  Jonas and Mishkin (2005) Inflation targeting in Transition Economies, in Bernanke, B. and Woodford, M. Inflation targeting debate, NBER 2005
  14. 14. Crisis  and  the  Bubble  Burst:     Quite few articles show how contagion of sub-prime MBS (mortgage based securities) collapse spread beyond the borders of US. e.g.:   Steven B. Kamin and Laurie Pounder DeMarco(2010): How Did a Domestic Housing Slump Turn into a Global Financial Crisis?; Federal Reserve System International Finance Discussion Papers 2010.   Brender A and Pisani, F.(2010), CEPS, Brussels.
  15. 15. Why  the  Bubble  Burst:     Similarly to the 1929 Great Depression crisis,   a sudden and sharp monetary tightening   with target rate rising 6% in period form 2004-2006   most likely triggered the 2007 bubble burst too. See:   Bernanke, Ben S. (1983), Non- Monetary Effects of the Financial Crisis in the Propagation of the Great Depression, American Economic Review,73(3), June 1983, 257-76.   Bernanke, B. 1995: The Macroeconomics of Great Depression, Journal of Money, Credit and Banking v.27, No. 1 (Feb. 1995) 1-28
  16. 16. Why  the  Bubble  Burst:  Debt  accelerator     I.e., the 2007 bubble burst was triggered by a combination of   interest rate increase and   an un-foreseen accelerating effect of high debt:   the unusually high borrowing   caused by the low rates in the previous period   had devastating effect on the disposable income of the borrowers once the rates suddenly rose, and, caused   a drop of the consumption demand and   the resulting drop in GDP   and bank bankruptcies
  17. 17. Why  the  Bubble  Burst:  Debt  accelerator       E.g. a cash and a interest only mortgage strapped household,   with mortgage 30% of disposable income   after interest rates doubled,   could not continue repaying mortgage which   now amounted to 60% - 90% of their disposable income.   Nor it could spend as usually.   This dual accelerating effect then lead to –  collapse of demand –  GDP, and –  bank bankruptcies, further accelerated by many fixed- rate mortgages
  18. 18. How  the  Bubble  Burst  accelerated:     than the known mechanisms of –  financial a(de)ccelerator and –  credit rationing –  animal (hurd) instinct   were also triggered fuelling the crisis further and,   CDO & CDS contagion farther.   Bernanke, B, Gertler, M. and Gildchrist, S. 1999: The Financial Accelerator in a Quantitative Business Cycle Framework, O J. Taylor and M. Woodford, eds. Handbook of Macroeconomics, North Holland, Amsterdam, 2000.   Stiglitz J.E and Greenwald, B.: Towards a New Paradigm in Monetary Economics, CUP 2003
  19. 19. Possible  ra.onale  for  keeping  target  rates  low  :     Keeping wolfs of Japan-like deflation outside gates   to encourage households’ consumption and growth   Fed unaware of looming inflation in 2003-4 due to incomplete real-time data,   FED using starting to use core rather than the headline inflation measure,   Model Insufficiencies   Distortionary political effect of Presidential elections in 2004 and 2008
  20. 20. Model  Insufficiencies     Bernanke, B, Gertler, M. and Gildchrist, S. 1999 as many other authors use standard linarised Euler equation •  ct= -σrt + E(ct+1)   but it can not capture the time-variant effect of time variable loans on σ or on E(ct+1) due to RE.   Also, most commonly used household budget constraint equations such as Smets and Wouters   accounts for income but it does not account for the loan borrowing effect.   See: Smets, F. and Wouters, .: Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach, American Ecnomic Revieew, 2007. (model in Appendix document)
  21. 21. Possible  ra.onale  for  keeping  target  rates  low  :   Distortionary effect of Presidential elections in 2004 and 2008:   Alesina et al(1992) and find   “Our results can be summarized as follows: ….   2) We see some evidence of “political monetary cycles,” that is, expansionary monetary policy in election years;   3) We also observe indications of “political budget cycles,” or “loose” fiscal policy prior to elections;   4) Inflation exhibits a post-electoral jump, which could be explained by either the pre-electoral “loose” monetary and fiscal policies and/or by an opportunistic timing of increases in publicly controlled prices, or indirect taxes.” see: - Alesina, A. Cohen G. D., Roubini, N. Macroeconomic Policy and Elections in OECD Democracies, Economics & Politics Volume 4, Issue 1, pages 130, March 1992 - Frenzese, R.J. : Electoral and Partisan Manipulation of Public Debt in Developed Democracies, 1956-90, Institute for Social Research, The University of Michigan working paper, May 1999
  22. 22. Conclusions:     Keeping interest rates low despite inflation and targeting rule, and,   then rising them sharply contributed to the housing market   bubble growing and   its bursting, respectively. Consequently,  some  form  of  either     loan  debt/GDP  and/or       housing   asset   price   bubble     targe4ng   should   be   included   in     the  stricter  followed  Taylor  rule,  or,       addi4onal  FM  control  mechanism       in  a  richer,  more  complex,  mul4ple   (heterogeneous)   agent   models   so   that  bubbles  can  be  contained  and   managed  beNer.  
  23. 23. Effects  of  infla.on  targe.ng  misfiring  on   development  of  housing  market  bubble   and  its  burs.ng  in  2008  credit  crisis   Author:   George  Perendia,  LMBS   e-­‐mail:  george@perendia.orangehome.co.uk   Thank you for listening!

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