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Wednesday, September 28, 2005

Yellen: There is a Bubble But Don’t Pop It With Monetary Policy

As noted here and more recently here, Alan Greenspan does not believe monetary policy should be used to deflate bubbles. Janet Yellen, president of the San Francisco Fed agrees. She believes that fundamentals do not fully explain the increase in housing prices so that there is a bubble component to housing price increases, and that the bubble poses a risk to the economy. But since the effects of a deflated bubble would be small, since the effects occur slowly giving monetary policy time to intervene after the collapse, and since there are potentially better tools such as regulation, there is no need for monetary policy to pinpoint bubbles except to the extent that the bubbles impact overall inflation:

Presentation to the members of Parliament at the Conference on US Monetary Policy, by Janet L. Yellen, President of the Federal Reserve Bank of San Francisco, The U.S Economy and Monetary Policy: ... I want to focus my remarks today on another longer-term issue, namely, the housing market ... The question is: ...Is there a house-price "bubble" that might collapse, and if so, what would that mean for the U.S. economy? To answer this question, let me begin by clarifying what I mean by the term "bubble." A bubble does not just mean that prices are rising rapidly—it's more complicated than that. Instead, a bubble means that the price of an asset—in this case, housing—is significantly higher than its fundamental value.

One common way of thinking about housing's fundamental value is to consider the ratio of housing prices to rents. ... Currently, the ratio for the U.S. is higher than at any time since data became available in 1970 ... Higher than normal ratios do not necessarily prove that there's a house-price bubble. House prices could be high for some good, fundamental reasons. ... Probably the most obvious candidate for a fundamental factor ... is low mortgage interest rates. ... While the fundamentals I've mentioned do play a role, the consensus seems to be that much of the unusually high price-to-rent ratio for housing remains unexplained. Moreover, with controversy over exactly why long-term interest rates have remained so low, we can't rule out the possibility that they would rise to a more normal relationship with short-term rates, and this obviously might take some of the "oomph" out of the housing market. So, while I'm certainly not predicting anything about future house price movements, I think it's obvious that the housing sector represents a risk to the U.S. outlook.

This brings me to the debate about how monetary policy should react to unusually high prices of houses—or other assets, for that matter. ... As a starting point, the issue is not whether policy should react at all; I believe there is quite general agreement that policy should be calibrated to the wealth effects of house prices on output and inflation. The debate lies in determining when, if ever, policy should be focused on deflating the asset price bubble itself. In my view, the ... decision to deflate an asset price bubble rests on positive answers to three questions. First, if the bubble were to collapse on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?

My answers to these questions in the shortest possible form are, "no," "no," and "no." ... In answer to the first question on the size of the effect, it could be large enough to feel like a good-sized bump in the road, but the economy would likely to be able to absorb the shock... In answer to the second question on timing, the spending slowdown that would ensue is likely to kick in gradually... That would give the Fed time to cushion the impact with an easier policy. In answer to the third question on whether monetary policy is the best tool to deflate a house-price bubble, ... For one thing, no one can predict exactly how much tightening would be needed, or by exactly how much the bubble should be reduced. Beyond that, a tighter policy to deflate a housing bubble could impose substantial costs on other sectors of the economy that would lead to equally unwelcome imbalances. Finally, it's possible that other strategies, such as tighter supervision or changes in financial regulation, would not only be more tailored to the problem, but also less costly to the economy. Taking all of these points into consideration, it seems that the arguments against trying to deflate a bubble outweigh those in favor of it. ... But let me stress that the debate surrounding these issues is still very much alive.

    Posted by on Wednesday, September 28, 2005 at 02:07 AM in Economics, Housing, Monetary Policy | Permalink  TrackBack (0)  Comments (7)



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