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Home Publications Blogs Beat the Press Is Raising Interest Rates the Fed's Only Tool for Bursting Bubbles?

Is Raising Interest Rates the Fed's Only Tool for Bursting Bubbles?

Wednesday, 09 October 2013 04:28

That's what the NYT told us this morning in a piece on what the Fed does and can do. The piece turns to a discussion of bubbles. It notes regulatory efforts to limit bubbles, then comments:

"The outstanding question is whether the Fed should try to pop bubbles if those first lines of defense don’t work. The problem with popping bubbles is that the Fed really only has one way to do it: by raising interest rates for the entire economy, which is something like dropping bombs on cockroaches."

Hmm, the only way for the Fed to pop bubbles is by raising interest rates? Let's think this one through.

Suppose we go back to the early days of the housing bubble in 2002, before the subprime nonsense had fully taken off. Let's imagine that then Federal Reserve Board Chairman Alan Greenspan had read a great little paper warning that house prices had grown out of line with trend values and that this increase had no plausible explanation in the fundamentals of the housing market. After having the Fed staff review the evidence, he concludes that there is in fact a dangerous bubble in the housing market.

Greenspan then prepares the following statement as his opening comment for the next time he gives congressional testimony:

"We are increasingly concerned about the bubble that has developed in the housing market. Prices are 20-30 percent above their trend levels, with no change in the fundamentals that can possibly explain this rise. At some point prices will inevitably fall back to their trend level.

"The Fed is prepared to take whatever steps are necessary to prevent any further growth in this bubble. This means that we will redouble our regulatory efforts to ensure that proper procedures are being followed in the issuance and securitization of mortgages in the institutions under our control. I will also urge the other federal and state regulators to take similar steps to ensure the integrity of new mortgages in the institutions under their control. I will follow this up by scheduling regular meetings with these regulators to discuss the steps they have taken to advance this goal.

"If improved regulatory scrutiny does not begin to rein in the size of the bubble in the housing market, then the Fed will be prepared to raise interest rates to bring about this result. We want to see nationwide house prices brought down to within 10 percent of their trend level by the end of 2004. If it is necessary to raise interest rates to reach this target then we will be prepared to do so, since the risks to the economy from further growth in the bubble are so great.

"Just to be clear, this means that people who buy homes at bubble inflated prices can anticipate large losses. For example, if a house is priced 25 percent above its trend level, a person who buys a home equal to four times their income can anticipate a loss equal to 80 percent of their annual income when the price reverts to the trend level. Those who issue and hold mortgages on homes purchased at bubble inflated prices can also anticipate large losses. Underwater mortgages default at far higher rates. This fact virtually guarantees that anyone holding a mortgage on a home that has lost much of its value will take a big hit on their investment."

Okay, now let's look at this in slow motion. Greenspan explicitly threatens to raise interest rates, but does not actually do so. He promises increased regulatory scrutiny (there was virtually none in the high bubble years of 2002-2006). And he warns both homebuyers and investors that they can expect large losses if they buy or finance a home at a bubble-inflated price.

The NYT is telling us that this statement by Greenspan (which can be repeated with various permutations at other times, just in case listeners find the original too confusing) would have no impact on house prices. Keep in mind we are now living in the era of "forward guidance" in which we believe that the Fed's statements on targets for future short-term interest rates can have a major impact on current long-term interest rates.

The NYT could be right, but I question that one. In any case, I would have certainly liked to see Greenspan try this one back in 2002 or have some future bank president to do the same facing similar circumstances. The NYT could be right and such statements may have no effect, but what would be the down side of trying? Millions of lives have been ruined and the economy has already lost close to $5 trillion of output because Greenspan did not make such a statement. And of course, he could always later decide to raise interest rates.

Comments (5)Add Comment
I hate interest rate adjustments.
written by Ralph Musgrave, October 09, 2013 5:49

The bubble inflating effects of low interest rates is just one illustration of the irrationality of using interest rates to adjust aggregate demand. Interest rate changes only adjust investment spending: completely stupid. If the economy needs stimulus, ALL SECTORS of the economy should be boosted.

Effecting stimulus ONLY VIA investment makes as much sense as effecting stimulus just via restaurants, massage parlors and car production.
Long Term Capital Management's Bubble
written by Robert Salzberg, October 09, 2013 6:17
Greeenspan, Summers and Rubin stopped Brooksley Born from regulating derivatives. The LTCM crisis might not have happened and much of the housing bubble would have been tamed if derivatives had been regulated.

there was no change in 2000 in deriv regulation
written by pete, October 09, 2013 9:53
Swaps had been exempt by regulation, and then the congress and Clinton put it in to the Commodity Exchange Act explicitly. If that had not happened, anyway, Ms Born would have been gone in January 2001, and replaced by someone who would have undoubtedlly kept the status quo, exempt via regs. Swaps were growing from the beginning of the bubble in 1995. Easy money made securitization especially profitable.
written by skeptonomist, October 09, 2013 5:02
Here's something else the Fed Chairman could say if markets start to go out of control: "If the bubble collapses and there is a major recession, the Fed won't be able to do much about it." Or if he can't bring himself to say that, at least he could refrain from promising that he could save the economy, as Bernanke did in his famous "Apology to Milton and Anna" speech. Or maybe economists could just place less credence in the idea that the Fed does control the economy. The first Maestro, Benjamin Strong (head of the NY Fed), made a similar promise with his 1928 claim that the Fed could prevent a major collapse by "flooding the street" with money.

The Fed did raise federal funds considerably 2004-6 from 1% to 5.25%, which should have sent a pretty strong signal apart from direct effects, but this did not seem to cause the bubble to deflate harmlessly. The Fed also raised rates 1928-9.
The Fed could have raised margin requirements to help pop the internet bubble
written by John Wright, October 09, 2013 9:31
I remember the Fed being encouraged to raise the stock margin requirements during the internet bubble, but neglecting to do so.

An earlier change of the accounting treatment of employee stock options could also have helped pop the internet bubble.

But the government let the bubble proceed a pace.

The fundamental problem is asset bubble popping is not something a personal wealth maximizing Fed chairman is likely to ever pursue.

What is the upside to the Fed Chairman? If they succeed in popping an asset bubble, the economy might not respond well and the chairman would be blamed.

If the Fed is able to get the bubble to deflate slowly, the beneficial effects may not be noticed and the chairman gets no credit.

Better to keep the bubble growing, retire and write the $8.5 million advance book as AG did.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.