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Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
Inflation targeting misfiring on development of housing market bubble
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Inflation targeting misfiring on development of housing market bubble

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  • The above graphs show rapid rise in US public debt frm 30% of GDP to around 60% during Reagan adminstratin in those very same early 1980’s, rising further untill Clinton adminstraation inceased taxes and started reducing the debt in absolute value (left diagram) and as a percentage of GDP (right diagram). It reached its recent minimum in the 2nd Q of 2001 – that is, just before the 2001 September 11 events and henceforth started its rapid growth ever since
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • On one hand, democratic governments had to spend more to please their voters and get re-elected and on the other hand (hand-in-hand), for the shear matter of credibility in their own publicised policies, the governments had to do what they also wanted themselves to do: to spend and borrow at a hight of their current incomes and resources, (rationally?) expecting that the perpetualy high growth and the low repay interest rates that will bring sustainability to their excessive borrowings
  • Transcript

    • 1. Effects of inflation targeting misfiring on development of housing market bubble and its bursting in 2008 credit crisis Author: George Perendia, LMBS e-mail: george@perendia.orangehome.co.uk
    • 2. Background: The so called "years of great moderation", the years of relatively stable and low inflation since early 1980, a period of reduction in government spending and period of the new inflation targeting mechanism providing stable and – low inflation (2%) and – low interest rates, -4 0 4 8 12 16 20 24 50 55 60 65 70 75 80 85 90 95 00 05 10 R_FED_TGT PI100*4 PRIME_R R_INTRBNK Inflation and interest rates: FED, Inerbank and Prime Loan 5 10 15 20 25 30 50 55 60 65 70 75 80 85 90 95 00 05 10 GC_PC_DFLT Government spending per capita (deflated)
    • 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! 30 40 50 60 70 80 90 100 50 55 60 65 70 75 80 85 90 95 00 05 10 PDEBT_PER_GDP_DFLT 8 12 16 20 24 28 1985 1990 1995 2000 2005 2010 INV_REAL_EST_LNS_PERGDP
    • 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 2002.15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10 GDP_PC 0 2000 4000 6000 8000 10000 12000 14000 50 55 60 65 70 75 80 85 90 95 00 05 10 GDP
    • 5. Crisis at The Gate: Despite IMF advices, several authors show, that 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; 0 2000 4000 6000 8000 10000 12000 14000 50 55 60 65 70 75 80 85 90 95 00 05 10 GDP 30 40 50 60 70 80 90 100 50 55 60 65 70 75 80 85 90 95 00 05 10 PDEBT_PER_GDP_DFLT
    • 6. Crisis and the Bubble Burst: Inflation mis-targeting 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. -4 0 4 8 12 16 20 24 1985 1990 1995 2000 2005 2010 R_FED_TGT PI100*4 PRIME_R -4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4
    • 7. Crisis and the Bubble Burst: Inflation mis-targeting Several 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 -4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4 8 12 16 20 24 28 1985 1990 1995 2000 2005 2010 INV_REAL_EST_LNS_PERGDP
    • 8. Crisis and the Bubble Burst: Inflation mis-targeting Whilst US Fed (and Mr B. Bernanke) reject that FED facilitated the housing bubble 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. -4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4 8 12 16 20 24 28 1985 1990 1995 2000 2005 2010 INV_REAL_EST_LNS_PERGDP
    • 9. Crisis and the Bubble Burst: Inflation mis-targeting 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 -4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4 8 12 16 20 24 28 1985 1990 1995 2000 2005 2010 INV_REAL_EST_LNS_PERGDP
    • 10. Crisis and the Bubble Burst: Inflation mis-targeting 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”-4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4
    • 11. Crisis and the Bubble Burst:
    • 12. Crisis and the Bubble Burst: Through 2003 FED moved from targeting headline to targeting the lower core inflation, however, Mishkin (2007) and Jonas and Mishkin (2005) state that the 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 2005-4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4
    • 13. Why the Bubble Burst: Similarly to the 1929 Great Depression crisis, when a sudden and sharp monetary tightening triggered the rash, the target rate rising 6% in period form 2004-2006, may have been the main trigger for 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) 1-28-4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4 -4 0 4 8 12 16 20 24 1985 1990 1995 2000 2005 2010 R_FED_TGT PI100*4 PRIME_R
    • 14. 10000 20000 30000 40000 50000 60000 70000 80000 90000 1985 1990 1995 2000 2005 2010 BNKRPC 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-4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4
    • 15. 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 drop, and – bank bankruptcies, further accelerated by – mortgage defaults -4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4 16 20 24 28 32 1985 1990 1995 2000 2005 2010 PC_PC
    • 16. 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 -4 -2 0 2 4 6 8 10 12 1985 1990 1995 2000 2005 2010 rr_fed_tgt_pi=r_fed_tgt-pi100*4 PI100*4 16 20 24 28 32 1985 1990 1995 2000 2005 2010 PC_PC
    • 17. Possible rationale 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
    • 18. 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)
    • 19. Possible rationale 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
    • 20. 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 targeting should be included in the stricter followed Taylor rule, or, additional FM control mechanism in a richer, more complex, multiple (heterogeneous) agent models so that bubbles can be contained and managed better. 8 12 16 20 24 28 1985 1990 1995 2000 2005 2010 INV_REAL_EST_LNS_PERGDP 30 40 50 60 70 80 90 100 50 55 60 65 70 75 80 85 90 95 00 05 10 PDEBT_PER_GDP_DFLT
    • 21. Effects of inflation targeting misfiring on development of housing market bubble and its bursting in 2008 credit crisis Author: George Perendia, LMBS e-mail: george@perendia.orangehome.co.uk Thank you for listening!

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