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

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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.