There is no bond market bubble

Bubbles, bubbles, everywhere bubbles. There is a lot of talk about bubbles among commentators and central bankers. One of the most common bubble fears is a fear of a bubble in the US bond market (just take a look at this recent “bond bubble”-story). Generally I am very skeptical about all kinds of bubble fears and that also goes for the fear of a bubble in the US bond market.

The general bond bubble story more or less assumes that quantitative easing from the Federal Reserve and other central banks has pushed down bond yields to artificially low levels and once QE is over the bond bubble will burst, bond yield will spike dramatically and send the US economy back into a major recession.

Should we fear this? Not really in my mind and I will try to show that in this blog post.

Inspired by Krugman and Mankiw

I very often disagree with Paul Krugman, but no one can dispute that he is a great communicator. Krugman is able to present complicated economic stories in a few sentences. This is exactly what he did in one of my favourite Krugman-blog posts back in 2010. The topic of the post was exactly the “bond bubble”. This is Krugman:

Here’s a thought for all those insisting that there’s a bond bubble: how unreasonable are current long-term interest rates given current macroeconomic forecasts? I mean, at this point almost everyone expects unemployment to stay high for years to come, and there’s every reason to expect low or even negative inflation for a long time too. Shouldn’t that imply that the Fed will keep short-term rates near zero for a long time? And shouldn’t that, in turn, mean that a low long-term rate is justified too?

So I decided to do a little exercise: what 10-year interest rate would make sense given the CBO projection of unemployment and inflation over the next decade?

… I decided to use the simplified Mankiw rule, which puts the same coefficient on core CPI inflation and unemployment. That is, it says that the Fed funds rate is a linear function of core CPI inflation minus the unemployment rate.

Krugman is basically using the Mankiw rule to forecast the Fed funds rate 10 years ahead and then he compared this forecast with the 10-year US government bond yield. It turned out that the 10-year yield was pretty well in line with the forecasted path for Fed Funds rates. I will now show that that is still the case.

Using the Mankiw rule to predict US monetary policy 10-years ahead

I have recently been playing a bit with the Mankiw rule (see here and here) so it is only natural to re-do Krugman’s small “experiment”.

Krugman is using CBO’s projections for core PCE inflation and unemployment. I will do the same (see the latest CBO forecast here) thing, but I will also use the FOMC’s recent projections (see here) for the same variables. I plug these projections into the Mankiw rule that I recently estimated. This gives us two forecasts for the Fed funds future rate for the coming 10-years. The graph below shows the two “forecasts”.

Mankiw rule FOMC CBO

Both forecasts (or maybe we should say simulations) point to interest rate hikes from the Fed in coming years. The forecast based on FOMC projections for unemployment and core inflation is a bit more “aggressive” in the rate hiking cycle than the Mankiw rule based on the CBO forecasts for the same variables.

The reason for this is primarily that the FOMC members expect unemployment to drop faster than forecasted by the CBO. Both the FOMC and CBO expects inflation to gradually increase to 2% over the coming 4 years.

The rule based on the FOMC projections indicates that the Fed funds target rate should be close to 3% in the “long run” (after 2018), while the CBO based rule is indicating a Fed funds rate around 2.6% i the long run. This difference is due to the FOMC expects unemployment at 5.0% in the long run, while the CBO expects unemployment at 5.5% in the long run.

I should stress that this is not my forecasts for the Fed funds rate as such, but rather an illustration of how we should expect the Fed’s policy rate to development over the coming 10 years if the Mankiw rule in general holds and we use the FOMC and CBO’s macroeconomic forecasts as input in this rule.

Drawing a (simplified) yield curve

We can now use these “predictions” to construct a (quasi) yield curve. Not to make things overly complicated (and spending to much time calculating the stuff…) I have simply constructed the “yield curve” by saying that “forecast” for for example the 2-year yield is simply the average of the predicted of the Fed funds rate in 2014 and 2015. Similarly the 5-yield is the average of the forecasted policy rate for 2014-2019. Hence, I disregard compounded interest and coupon payments.

The graph below shows the actual US yield curve compared with the two quasi-yield curve based on the two Mankiw rule based predictions for the Fed funds rate in the coming 10 years.

yield curve Fed Mankiw

Looking at the graph we imitatively spot two things:

First of all we see that the FOMC curve and CBO curve are considerably “higher” than the actual yield curve for the next couple of years. This should not be a surprise given the fact that we already know that forecasts based on the Mankiw rule is too “hawkish” compared to the actual Fed policy in 2014. Hence, the “predicted” rate for 2014 is 75-100bp too high. The reason for this is among other things that the simple Mankiw rule does not take into account “discouraged worker”-effects on the labour market, which seems to have been a a major problem in the past 5-6 years. Furthermore, the rule ignores that the Fed over the past 5-6 years more or less consistently has undershot it’s 2% inflation target. I have discussed these factors in my previous post.

These factors mean that we should probably pushed down the “rate path” in the next couple of years and that means that the yield curve does not look to be too “low” for 2-year or 5-years (very broadly speaking).

Second, we see that if we look at the 10-year yield we see that it is more or less exactly where the FOMC curve “predict” it to be (around 2.6%). We can of course not directly compare the two as I have not taken compounded interest and coupon payments into account (which would push the FOMC curve up), but on the other hand we should also remember that the Mankiw rule is too “hawkish” for the “early period” (which should push the FOMC curve down along the curve).

There is no “bond bubble”

I believe that the discussion above shows that US bond yields pretty well reflect realistic expectations to Federal Reserve policy over the coming decade given the FOMC’s and the CBO’s expectations for US unemployment and core inflation and it is therefore hard in my view to justify the claim that there is a bubble in the US bond market. That of course does not mean that yields cannot go up. They very likely will if FOMC’s and CBO’s expectations particularly for the US labour market are correct.

And the bond market might of course also be 50bp wrong is one or the other direction, but I find it very hard to see why US bond yields should suddenly spike 200 or 300bp as some of doomsayers are claiming.

And finally I should stress that this is not investment advice and I am not making any recommendations to sell or buy US Treasury bonds and the market might go in whatever direction.

Instead my point here is to argue that policy makers – the Fed – should not be overly concerned that quantitative easing has caused a bond bubble. It has not. If anything bond yields are this low because the Fed has not eased monetary policy enough rather than too much.

Related posts:

There is no bubble in the US stock market

The stock market has reached “a permanently high plateau” (if the Fed does not mess up again…)

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

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Stock picker Janet Yellen

If you are looking for a new stock broker look no further! This is Fed chair Janet Yellen at her testimony in the US Senate yesterday:

“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

This is quite unusual to say the least that the head of most powerful central bank in the world basically is telling investors what stocks to buy and sell.

Unfortunately it seems to part of a growing tendency among central bankers globally to be obsessing about “financial stability” and “bubbles”, while at the same time increasingly pushing their primary nominal targets in the background. In Sweden an obsession about household debt and property prices has caused the Riksbank to consistently undershot its inflation target. Should we now start to think that the Fed will introduce the valuation of biotech and social media stocks in its reaction function? Will the Fed tighten monetary policy if Facebook stock rises “too much”? What is Fed’s “price target” in Linkedin?

I believe this is part of a very unfortunate trend among central bankers around the world to talk about monetary policy in terms of “trade-offs”. As I have argued in a recent post in the 1970s inflation expectations became un-anchored exactly because central bankers refused to take responsibility for providing a nominal anchor and the excuse was that there are trade-offs in monetary policy – “yes, we can reduce inflation, but that will cause unemployment to increase”.

Today the excuse for not providing a nominal anchor is not unemployment, but rather the perceived risk of “bubbles” (apparently in biotech and social media stocks!)  The result is that inflation expectations again are becoming un-anchored – this time the result, however, is not excessively high inflation, but rather deflation. The impact on the economy is, however, the same as the failure to provide a nominal anchor will make the working of the price system less efficient and therefore cause a general welfare lose.

I am not arguing that there is not misallocation of credit and capital. I am just stating that it is not a task for central banks to deal with these problems. In think that moral hazard problems have grown significantly since 2008 – particularly in Europe. Therefore governments and international organisations like the EU and IMF need to reduce implicit and explicit guarantees and subsidies to (other) governments, banks and financial institutions to a minimum. And central banks should give up credit policies and focus 100% on monetary policy and on providing a nominal anchor for the economy and leave the price mechanism to allocate resources in the economy.

There is no bubble in the US stock market

Before you start reading this post note that I am not an equity market analyst and this is not investment advice. Rather it is an attempt to discuss the impact of monetary easing on the US stock market and to what extent the Fed’s actions have created a stock market bubble.

It is quite often said these days that the recovery we have seen in the US stock markets since early 2009 in some way is “phony” or “fake”, and that it has been driven by “easy money”. Even some policy makers, both in the US and other places, seem to think that there is a bubble in the global stock markets, which is a result of overly easy monetary policy.

To test these views in a simple way, I have estimated a model for the S&P500 going back to 1960.  It is a simple OLS regression. You can do something more fancy, but that is not the point here. It is all indicative. If you have a better model, I would love to see it.

Take a look at the graph below. The blue is the actual performance of S&P500, while the green line is the model “prediction”. Please note that I have estimated the model until 2007 to avoid the results being influenced by the monetary policy shift over the past five years (it doesn’t change the result in any substantial way, however, to estimate the model until today).

SP500 model

As you see, the model fits the actual performance of S&P500 over the decades quite well. The model is quite simple. I used only three explanatory variables – A corporate Aaa-rate long-term bond yield to capture funding costs and/or an alternative investment to stocks. I used the nominal Personal Consumption Expenditure to capture demand in the US economy. It is also a proxy for earnings growth and finally I used the ISM New Orders index as a proxy for growth expectations. All variables have the expected signs and are statistically significant.

Yes, it is a simple model, but it seems to work quite well in terms of fitting the actual level on the S&P500 over the years.

If anything stocks are still cheap (and monetary policy too tight)

As mentioned, I estimated the model with data until 2007, but I have used the model to “predict” how the stock market should have performed according to the model from 2008 until today.

The results are quite clear: Since 2008, stock prices have consistently been lower than what the model predicts. Only recently have stock prices approached the level predicted by the model. Based on this, it is quite hard to argue that stock prices in the US are overvalued. In fact if anything stocks remain “cheap” relative to the model predictions.

I don’t want to argue this too strongly and I am certainly not giving any advice on whether to buy or sell the US stock market at these levels – all kind of things tend to move the market up and down. What I am arguing is that the view that there is a bubble in the US stock market is pretty hard to justify based on my simple model. If you can come up with a better model, which can show that there is a bubble, I am all ears.

Therefore, it is very hard to argue in my view that overly easy monetary policy has distorted the pricing of US stocks. What has happened rather is that stocks became extremely cheap relative to “fundamentals” in early 2009, and what we have seen in the past five years is a closing of this “valuation gap”. Has monetary policy helped close the “gap”? Yes, that is likely, but that is not the same as saying that there is a bubble.

Concluding, there is no empirical reason in my view to claim that US monetary policy has unduly inflated US asset prices. And hence the performance of the US stock market over the past five years is not an argument for monetary tightening. It anything it is an argument that monetary policy has remained too tight.

PS if you are interested in the model output see below (it is not rocket science):

  • Model 1

    S&P500, rebase 01-01-1960 = 100.0

    • Observations 576
      Degrees of freedom 572
      R2 0,9597105111
      F 4541,7504443086
      Prob-value(F) 0
      Sum of squared errors 16279,404325032
      Standard error of regression 5,3348380549
      Durbin-Watson 0,0489587816
      AIC 6,1933143441
      HQ 6,2051117912
      Schwarz 6,2235650918
    • Coefficients Standard error t Prob-value
      Intercept -627,703293948 7,0591041987 -88,9210976745 0
      x1 -3,4836423233 0,096018312 -36,2810202582 0
      x2 28,8240799392 0,2485205896 115,9826635779 0
      x3 -0,0228854283 0,0303242775 -0,7546899778 0,4507456199
    • Legend
      x1 Corporate Benchmarks, Moody’s Aaa-Rated Long-Term, Yield, Average, USD
      x2 PCE
      x3 ISM PMI, Manufacturing Sector, New orders, SA
    • Covariance matrix
      Intercept x1 x2 x3
      Intercept 49,8309520883 0,0191128279 -1,6803093367 -0,067856727
      x1 0,0191128279 0,0092195162 -0,0048925278 0,0007896205
      x2 -1,6803093367 -0,0048925278 0,0617624835 0,0003876941
      x3 -0,067856727 0,0007896205 0,0003876941 0,0009195618

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

Among ‘internet Austrians’ there is an idea that there is gigantic bubble in the global bond markets and when this bubble bursts then the world will come to an end (again…).

The people who have these ideas are mostly people who never really studied any economics and who get most of their views on economics from reading more or less conspiratorial “Austrian” school websites. Just try to ask them and they will tell you they never have read any economic textbooks and most of them did not even read Austrian classics as “Human Action”. So in that sense why should we worry about these views?

And why blog about it? Well, because it is not only internet Austrians who have these ideas. Unfortunately many central bankers seem to have the same kind of views.

Just have a look at this from the the Guardian:

A key Bank of England policymaker has warned of the risks to global financial stability when “the biggest bond bubble in history” bursts.

In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability, admitted the central bank’s new financial policy committee is taking too long to force banks to hold more capital and appeared to criticise the bank’s culture under outgoing governor Sir Mervyn King.Haldane told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk “I feel acutely right now”.

He also said banks have now put the threat of cyber attacks on the top of their the worry-list, replacing the long-running eurozone crisis.

“You can see why the financial sector would be a particularly good target for someone wanting to wreak havoc through the cyber route,” Haldane said.

But he described bond markets as the main risk to financial stability. “If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally.” he said. There had been “shades of that” in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus.

“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history,” Haldane said. “We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted.”

I must admit that I am somewhat shocked by Haldane’s comments as it seems like Haldane actually thinks that monetary easing is the cause that global bond yields are low. The Bank of England later said it was not the view of the BoE, but Haldane’s “personal” views.

If Haldane ever studied Milton Friedman it did not have an lasting impact on his thinking. Milton Friedman of course told us that low bond yields is not an result of easy monetary policy, but rather a result of excessively TIGHT monetary policy. Hence, if monetary conditions are tight then inflation and growth expectations are low and as a consequence bond yields will also be low.

Hence, Milton Friedman would not be surprised that Japanese and US bond yields have risen recently on the back of monetary easing being implemented in the US and Japan.

In fact the development in global fixed income markets over the past five years is a very strong illustration that Friedman was right – and why Haldane’s fears are misguided. Just take a look at the graph below – it is 10-year US Treasury bond yields.

10y UST

(If you think you saw this graph before then you are right – you saw it here).

If Haldane is right then we should have seen bond yields decrease following the announcement of monetary easing. However, the graph shows that the opposite have happened.

Hence, the announcement of TAP and the dollar swaps lines in early 2009 was followed by an significant INCREASE in US (and global) bond yields. Similarly the pre-announcement of ‘QE2′ in August 2010 also led to an increase in bond yields.

And finally the latest sell-off in the global fixed income markets have coincided with monetary easing from the fed (the Evans rule) and the Bank of Japan (‘Abenomics’)

If you think there is a bond bubble

then blame the ECB’s rate hikes in 2011

Looking at US 10-year yields over the past five years we have had three major “down-legs”. The first down-leg followed the collapse of Lehman Brothers in October 2008. The second down-leg played out in the first half of 2010 following the hike in Federal Reserve’s discount rate in February 2010 and the People Bank of China’s increase in the reserve requirement in January 2010.

However, the biggest down-leg in US 10-year bond  yields followed the ECB’s two rate hikes of 2011 (April and July). Believe it or not, but the ECB was “able” to reduce US 10-bond yields more than the collapse of Lehman Brothers did.

Hence, if there is a ‘bubble’ in the global fixed income markets it has not been caused by monetary easing. No if anything it is a result of excessively tight monetary conditions.

In fact it is completely absurd to think that global bond yields are low as a result of central bank ‘manipulation’. Global bond yields are low because investors and households fear for the future – fears of low growth and deflationary tendencies. Global bond yields are low because monetary policy have been excessive tight.

Rejoice! Yields are rising

Unlike Andy Haldane I do not fear that day the bond ‘bubble’ (it is not a bubble!) will burst. In fact I look forward to the day US bond yields (and UK bond yields for that matter) once again are back to 5%. Because that would mean that investors and households again would believe that we are not heading for deflation and would once again believe that we could have ‘normal’ GDP growth.

And unlike Haldane I don’t believe that higher bond yields would lead to financial armageddon and I don’t believe that Japan will default if Japanese bond yield where to rise to 3 or 4%. Banks and countries do not go belly up when growth takes off. In fact the day US bond yields once again is back around 5% we can safely conclude that the Great Recession has come to an end.

Concluding, there is no ‘bond bubble’ and Andy Haldane should not have sleepless nights over it. The Bank of England did not cause UK yields to drop – or rather maybe it did, but only because monetary policy has been too tight rather than too easy.

PS I never heard any of these ‘bubble mongers’ explain why Japanese property prices and equity prices have been trending downward for nearly two decades despite interest rates being basically at zero in Japan.

PPS the graph above also shows that “Operation Twist” in 2011 failed to increase growth and inflation expectations. Any Market Monetarists would of course have told you that “Operation Twist” would fail as it did nothing to increase the money base or increase the expectation for future money base expansion.

—–

Related posts:

When US 30-year yields hit 5% the Great Recession will be over
Confused central banks and the need for an autopilot
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
Tight money = low yields – also during the Great Recession

Are half a million hardworking Poles to blame for the UK real estate bubble?

The answer to the question of course is no, but let me tell the story anyway. It is a story about positive supply shocks, inflation targeting, relative inflation and bubbles.

In 2004 Poland joined the EU. That gave Poles the possibility to enter the UK labour market (and other EU labour markets). It is estimated that as much as half a million poles have come to work in the UK since 2004. The graph below shows the numbers of Poles employed in the UK economy (I stole the graph from Wikipedia)

Polish-born_people_in_employment_in_the_UK_2003-2010_-_chart_2369a_at_statistics_gov_uk

 

 

 

 

 

 

 

Effectively that has been a large positive supply shock to the UK economy. In a simple AS/AD model we can illustrate that as in the graph below.

Positive supply shock

The inflow of Polish workers pushes the AS curve to the right (from AS to AS’). As a result output increases from Y to Y’ and the price level drops to P’ from P.

Imagine that we to begin with is exactly at the Bank of England’s inflation target of 2%.

In this scenario a positive supply – half a million Polish workers – will push inflation below 2%.

As a strict inflation targeting central bank the BoE in response will ease monetary policy to push inflation back to the 2% inflation target.

We can illustrate that in an AS/AD graph as a shift in the AD curve to the right (for simplicity we here assume that the BoE targets the price level rather than inflation).

The BoE’s easing will keep that price level at P, but increase the output to Y” as the AD curve shifts to AD’. Note that that assumes that the long-run AS curve also have shifted – I have not illustrated that in the graphs.

Positive supply shock and demand shock

At this point the Austrian economist will wake up – because the BoE given it’s monetary easing in response to the positive supply shock is creating relative inflation.

Inflation targeting is distorting relative prices

If we just look at this in terms of the aggregate price level we miss an important point and that is what is happening to relative prices.

Hence, the Polish workers are mostly employed in service jobs. As a result the positive supply shock is the largest in the service sector. However, as the service sector prices fall the BoE will push up prices in all other sectors to ensure that the price level (or rather inflation) is unchanged. This for example causes property prices to increase.

This is what Austrian economists call relative inflation, but it also illustrates a key Market Monetarist critique of inflation targeting. Hence, inflation targeting will distort relative prices and in that sense inflation targeting is not a “neutral” monetary policy.

On the other hand had the BoE been targeting the nominal GDP level then it would have allowed the positive shock to lead to a permanent drop in prices (or lower inflation), while at the same time kept NGDP on track. Therefore, we can describe NGDP level targeting as a “neutral” monetary policy as it will not lead to a distortion of relative prices.

This is one of the key reasons why I again and again have described NGDP level targeting as the true free market alternative – as NGDP targeting is not distorting relative prices contrary to inflation targeting,which distorts relative prices and therefore also distorts the allocation of labour and capital. This is basically an Austrian style (unsustainable) boom that sooner or later leads to a bust.

So is this really the story about UK property prices?

It is important to stress that I don’t necessarily think that this is what happened in the UK property market. First, of all UK property prices seemed to have taken off a couple of years earlier than 2004 and I have really not studied the data close enough to claim that this is the real story. However, that is not really my point. Instead I am using this (quasi-hypothetical) example to illustrate that central bankers are much more likely to creating bubbles if they target inflation rather than the NGDP level and it is certainly the case that had the BoE had an NGDP level targeting (around for example a 5% trend path) then monetary policy would have been tighter during the “boom years” than was actually the case and hence the property market boom would likely have been much less extreme.

But again if anybody is to blame it is not the half million hardworking Poles in Britain, but rather the Bank of England’s overly easing monetary policy in the pre-crisis years.

PS I am a bit sloppy with the difference between changes in prices (inflation) and the price level above. Furthermore, I am not clear about whether we are talking about permanent or temporary supply shocks. That, however, do not change the conclusions and after all this is a blog post and not an academic article.

You have to thank Scandinavian Airlines for this post – kind of a tribute to Nouriel Roubini

Dear friends if you like to read my blog posts you will have to thank Scandinavian Airlines for this one. I am stuck in Heathrow Airport for now. Cancellations and delays of my flight from London to Copenhagen mean that this has been a rather unproductive day. However, that is part of the life as a traveling standup comedian/economist – we spend a lot of time in airports. Today, however, has been a bit too much – particularly taking into account that my next trip will be on Wednesday.

The purpose of my next trip is to go to Lithuania where I will be battling it out with Dr. Doom aka Nouriel Roubini. Nouriel and I have known each other for 6-7 years. We used to agree that we were heading for trouble and we also agree that the ECB failed on monetary policy. But fundamentally Nouriel is a Austro-Keynesian – a position that I strongly disagrees with. The Austro-keynesian perception of the world, however, is very common these days: During the later years of the Great Moderation we overspend and as a result we are now having a hangover in the form of repaying debt and therefore having lower private consumption growth and lower investment growth. It is not clear why we overspend – the Austro-keynesians tend to believe that it was a combination of overly easy monetary policy and “animal spirits” that did it. I think this story is utterly wrong, but nonetheless it seems to be the majority view these days.

For the last four years Nouriel has been negative about the world. That to some extent has been right, but for the wrong reasons. Nouriel never forecasted that the ECB would fail so utterly – even though he correctly has criticized the ECB for overly tight monetary policy he certainly did not forecast how events played out.

In general I am very skeptical about making heroes out of people who got it right in 2008 – whether it is Nouriel Roubini or Peter Schiff or for that matter myself and my ultra negative call on Iceland and Central and Eastern Europe in 2006/7. The fact is that most of the people who got it right in 2008 had been negative for years (including myself who turned bearish in 2006). Peter Schiff for example has been screaming hyperinflation for years. He has been utterly wrong about that. Roubini has been negative on the US stock market for years. He has been utterly wrong on that. I was right about being negative about Iceland, but the bullish call I made on Iceland a year ago or so actually has been much more correct than my negative call in 2006 (it took much longer for the crisis to materialize than I expected), but nobody cared about that because being bullish is never as “fun” as being negative.

If all economists in the world throw out random forecasts all time some of them will be right some of the time. The more crackpot forecast you make the more spectacularly correct they will seem to be when they happen. Nassim Taleb even got famous for saying that rare events (“black swans”) happen and then a black swan event happened. Taleb didn’t forecast anything. But he is a celebrity anyway. Paradoxically the logic of his argument is that you can’t forecast anything and despite of that he is telling people how to invest based on this.

I am proud of the few things I forecasted right in my life, but frankly speaking getting a forecast right doesn’t make you a good economist. The popular press was suggesting that Robert Shiller should get the Nobel Prize for forecasting both the bust of the IT bubble and the property market bubble. Please come on – that is not the work of an economist, but that of gambler. Robert Shiller is a clever guy, but I don’t think his biggest achievement is forecasting the bust of two bubbles – that is just pure luck (I had similar views to Shiller in both cases, but do not claim to be a great forecaster). Shiller’s biggest achievement is his work on what he calls “macro markets” and his book on that topic. That work has gotten absolutely no attention, but it is very clever and significantly more interesting than his work on “bubbles”.

My friend Nouriel Roubini is a great economist, but my respect for himhas nothing to do with his bearish calls on the global economy. I, however, was a huge fan of Nouriel well before he made those bearish forecasts and before I ever met him. Nouriel has done amazingly good work with among others Alberto Alesina on political business cycles and the use of game theory in understanding monetary and fiscal policy. That didn’t make Nouriel an economic superstar, but it inspired me to study these topics. So I am forever grateful to Nouriel for that.

So Nouriel see you in a few days. As always it will be great seeing you. We will argue and you will tell me – as usual – that I am overly optimistic despite my gloomy view of the world and my distrust of policy makers. But no matter what it will be great fun. See you in Vilnius! And if you haven’t been to that great city before I am sure I will have time to show you a bit of it.

Dangerous bubble fears

Here is Swedish central bank governor Stefan Ingves in an op-ed piece in the Swedish newspaper Svenska Dagbladet last week:

“I also have to take responsibility for the long term consequences of today’s monetary policy…And there are risks associated with an all too low interest rate over a long period, which cannot be ignored.”

Said in another way if we keep interest rates too low we will get bubbles. So despite very clear signs that the Swedish economy is slowing Ingves would not like to ease monetary policy. Ingves in that sense is similar to many central bankers around the world. Many central bankers have concluded that the present crisis is a result of a bubble that bursted and the worst you could do is to ease monetary policy – even if the economic data is telling you that that is exactly what you should.

The sentiment that Ingves is expressing is similar to the view of the ECB and the fed in 2008/9: We just had a bubble and if we ease too aggressively we will get another one. Interestingly enough those central banks that did well in 2008/9 and eased monetary policy more aggressively and therefore avoided major crisis today seem to be most fearful about “bubbles”. Take the Polish central bank (NBP). The NBP in 2009 allowed the zloty to weaken significantly and cut interest rates sharply. That in my view saved the Polish economy from recession in 2009 – Poland was the only country in Europe with positive real GDP growth in 2009. However, today the story is different. NBP hiked interest rates earlier in the year and is now taking very long time in easing monetary policy despite very clear signs the Polish economy is slowing quite fast. In that sense you can say the NBP has failed this year because it did so well in 2009.

The People’s Bank of China in many ways is the same story – the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.

So the story is the same in Sweden, Poland and China. The countries that escaped the crisis did so by easing monetary conditions. As their exports collapsed domestic demand had to fill the gap and easier monetary policy made that possible. So it not surprising that these countries have seen property prices continuing to increase during the last four years and also have seen fairly strong growth in private consumption and investments. However, this now seem to be a major headache for central bankers in these countries.

I think these bubble fears are quite dangerous. It was this kind of fears that led the fed and the ECB to allow monetary conditions to become excessive tight in 2008/9. Riksbanken, NBP and the PBoC now risk making the same kind of mistake.

At the core of this problem is that central bankers are trying to concern themselves with relative prices. Monetary policy is very effective when it comes to determine the price level or nominal GDP, but it is also a very blunt instrument. Monetary policy cannot – and certainly should not – influence relative prices. Therefore, the idea that the central bank should target for example property prices in my view is quite a unhealthy suggestion.

Obviously I do not deny that overly easy monetary policy under certain circumstances can lead to the formation of bubbles, but it should not be the job of central bankers to prick bubbles.

The best way to avoid that monetary policy do not create bubbles is that the central bank has a proper monetary target such as NGDP level targeting. Contrary to inflation targeting where positive supply shocks can lead to what Austrians call relative inflation there is not such a risk with NGDP level targeting.

Let’s assume that the economy is hit by a positive supply shock – for example lower import prices. That would push down headline inflation. An inflation targeting central bank – like Riksbanken and NBP – in that situation would ease monetary policy and as a result you would get relative inflation – domestic prices would increase relative to import prices and that is where you get bubbles in the property markets. Under NGDP level targeting the central bank would not ease monetary policy in response to a positive supply shock and inflation would drop ease, but the NGDP level would on the other hand remain on track.

However, the response to a demand shock – for example a drop in money velocity – would be symmetric under NGDP level targeting and inflation target. Both under IT and NGDP targeting the central bank would ease monetary policy. However, this is not what central banks that are concerned about “bubbles” are doing. They are trying to target more than one target. The first page in the macroeconomic textbook, however, tells you that you cannot have more policy targets than policy instruments. Hence, if you target a certain asset price – like property prices – it would mean that you effectively has abandoned your original target – in the case of Riksbanken and NBP that is the inflation target. So when governor Ingves express concern about asset bubbles he effective has said that he for now is not operating an inflation targeting regime. I am sure his colleague deputy governor Lars E. O. Svensson is making that argument to him right now.

I don’t deny that bubbles exist and I am not claiming that there is no bubbles in the Swedish, Polish or Chinese economies (I don’t know the answer to that question). However, I am arguing that monetary policy is a very bad instrument to “fight” bubbles. Monetary policy should not add to the risk of bubbles, but “bubble fighting” should not be the task of the central bank. The central bank should ensure nominal stability and let the market determine relative prices in the economy. Obviously other policies – such as tax policy or fiscal policy should not create moral hazard problems through implicit or explicit guarantees to “bubble makers”.

Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles. I doubt that the Riksbank, NBP or the PBoC will make the same kind of mistakes, but bubbles have clearly led all three central banks to become overly cautious and as a result the Swedish, the Polish and the Chinese economy are now cooling too much.

I should stress that I do not suggest some kind of “fine tuning” policy, but rather I suggest that central banks should focus on one single policy target – and I prefer NGDP level targeting – and leave other issues to other policy makers. If central banks are concerned about bubbles they should convince politicians to implement policies that reduce moral hazard rather than trying to micromanage relative prices and then of course focus on a proper and forward looking monetary policy target like NGDP level targeting.

PS Note that I did not mention the interest rate fallacy, but I am sure Milton Friedman would have told governor Ingves about it.
PPS You can thank Scandinavian Airlines for this blog post – my flight from London to Copenhagen got cancelled so I needed to kill some time before my much later flight.

Related posts:

Boom, bust and bubbles
The luck of the ‘Scandies’
Four reasons why central bankers ignore Scott Sumner’s good advice

The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:

(1) NGDP=P*RGDP

where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:

(1)’ P=NGDP/RGDP

In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

Stable NGDP growth can stabilise the property market

It is often argued that falling and low interest rates sparked a global housing bubble. However, the empirical evidence of this is actually quite weak and the development in global property markets is undoubtedly much more complicated than often argued in the media – and by some economists.

Personally I have always been critical about the sharp rise in property prices we have seen in many countries, but trusting the markets I have also been critical about simplified explanations of that increase.

Now a new paper by Kenneth N. Kuttner provides more empirical evidence on the global property market trends. Here is the abstract of Kuttner’s paper “Low Interest Rates and Housing Bubbles: Still No Smoking Gun” (I stole the reference from Tyler Cowen):

“This paper revisits the relationship between interest rates and house prices. Surveying a number of recent studies and bringing to bear some new evidence on the question, this paper argues that in the data, the impact of interest rates on house prices appears to be quite modest. Specifically, the estimated effects are uniformly smaller than those implied by the conventional user cost theory of house prices, and they are too small to explain the previous decade’s real estate boom in the U.S. and elsewhere. However in some countries, there does appear to have been a link between the rapid expansion of the monetary base and growth in house prices and housing credit.”

Hence, we can not conclude that low interest rates generally created housing bubbles around the world.

Kuttner has for example an interesting point about the rise in US property prices and interest rates (UC = user costs/interest rates):

 “For one thing, the timing does not line up. House prices began to appreciate in 1998, three years before the drop in UC, and by 2001 the FMHPI index  (property prices) had already outpaced rents by 10%. The initial stages of the boom therefore appear to have had nothing to do with interest rates. It is only after 2001 that low interest rates enter the picture.”

Luckily for me Kuttner highlights two countries as having the most spectacular property market booms – Iceland and Estonia. I guess it should be known to my readers that I on my part (in my dayjob) warned about the boom-bust risks in both Iceland (in 2006) and in Estonia (in 2007). In these countries Kuttner demonstrates that there is a close relationship between overly easy monetary policy (strong money base growth) and the increase in property prices. These are, however, special cases and even though we saw a global trend towards higher real property prices in the prior to 2008 there are very significant differences from country to country.

Kuttner’s paper is very interesting and do certainly shed some light on the developments in the global property markets. However, I miss one thing and that is what impact the increased macroeconomic stability during the Great Moderation had on property prices. I have done some very simple and preliminary econometric studies of the impact of the (much) lower variance in NGDP growth during the Great Moderation on the US stock market. I have not done a similar study of the impact of the property markets, but I am sure that if Kuttner had included for example a 5-year rolling variance of NGDP growth in this estimates then he could have demonstrated that the increased stability of NGDP growth of the Great Moderation had a very significant impact on property prices. In fact I will argue that the increase in the stability of NGDP growth during the Great Moderation played at least as big a role in the increase in property prices as the drop in real interest rates. I challenge anybody to test this empirically.

If I am right then the best way for central banks to end the property market bust is to stabilise NGDP growth.

 

NGDP targeting would have prevented the Asian crisis

I have written a bit about boom, bust and bubbles recently. Not because I think we are heading for a new bubble – I think we are far from that – but because I am trying to explain why bubbles emerge and what role monetary policy plays in these bubbles. Furthermore, I have tried to demonstrate that my decomposition of inflation between supply inflation and demand inflation based on an Quasi-Real Price Index is useful in spotting bubbles and as a guide for monetary policy.

For the fun of it I have tried to look at what role “relative inflation” played in the run up to the Asian crisis in 1997. We can define “relative inflation” as situation where headline inflation is kept down by a positive supply shock (supply deflation), which “allow” the monetary authorities to pursue a easy monetary policies that spurs demand inflation.

Thailand was the first country to be hit by the crisis in 1997 where the country was forced to give up it’s fixed exchange rate policy. As the graph below shows the risks of boom-bust would have been clearly visible if one had observed the relative inflation in Thailand in the years just prior to the crisis.

When Prem Tinsulanonda became Thai Prime Minister in 1980 he started to implement economic reforms and most importantly he opened the Thai economy to trade and investments. That undoubtedly had a positive effect on the supply side of the Thai economy. This is quite visible in the decomposition of the inflation. From around 1987 to 1995 Thailand experience very significant supply deflation. Hence, if the Thai central bank had pursued a nominal income target or a Selgin style productivity norm then inflation would have been significantly lower than was the case. Thailand, however, had a fixed exchange rate policy and that meant that the supply deflation was “counteracted” by a significant increase in demand inflation in the 10 years prior to the crisis in 1997.

In my view this overly loose monetary policy was at the core of the Thai boom, but why did investors not react to the strongly inflationary pressures earlier? As I have argued earlier loose monetary policy on its own is probably not enough to create bubbles and other factors need to be in play as well – most notably the moral hazard.

Few people remember it today, but the Thai devaluation in 1997 was not completely unexpected. In fact in the years ahead of the ’97-devaluation there had been considerably worries expressed by international investors about the bubble signs in the Thai economy. However, the majority of investors decided – rightly or wrongly – ignore or downplay these risks and that might be due to moral hazard. Robert Hetzel has suggested that the US bailout of Mexico after the so-called Tequila crisis of 1994 might have convinced investors that the US and the IMF would come to the rescue of key US allies if they where to get into economic troubles. Thailand then and now undoubtedly is a key US ally in South East Asia.

What comes after the bust?

After boom comes bust it is said, but does that also mean that a country that have experience a bubble will have to go through years of misery as a result of this? I am certainly not an Austrian in that regard. Rather in my view there is a natural adjustment when a bubble bursts, as was the case in Thailand in 1997. However, if the central bank allow monetary conditions to be tightened as the crisis plays out that will undoubtedly worsen the crisis and lead to a forced and unnecessarily debt-deflation – what Hayek called a secondary deflation. In the case of Thailand the fixed exchange rate regime was given up and that eventually lead to a loosening of monetary conditions that pulled the

NGDP targeting reduces the risk of bubbles and ensures a more swift recovery

One thing is how to react to the bubble bursting – another thing is, however, to avoid the bubble in the first place. Market Monetarists in favour NGDP level targeting and at the moment Market Monetarists are often seen to be in favour of easier monetary policy (at least for the US and the euro zone). However, what would have happened if Thailand had had a NGDP level-targeting regime in place when the bubble started to get out of hand in 1988 instead of the fixed exchange rate regime?

The graph below illustrates this. I have assumed that the Thailand central bank had targeted a NGDP growth path level of 10% (5% inflation + 5% RGDP growth). This was more or less the NGDP growth in from 1980 to 1987. The graph shows that the actually NGDP level increased well above the “target” in 1988-1989. Under a NGDP target rule the Thai central bank would have tightened monetary policy significantly in 1988, but given the fixed exchange rate policy the central bank did not curb the “automatic” monetary easing that followed from the combination of the pegged exchange rate policy and the positive supply shocks.

The graph also show that had the NGDP target been in place when the crisis hit then NGDP would have been allowed to drop more or less in line with what we actually saw. Since 2001-2 Thai NGDP has been more or less back to the pre-crisis NGDP trend. In that sense one can say that the Thai monetary policy response to the crisis was better than was the case in the US and the euro zone after 2008 – NGDP never dropped below the pre-boom trend. That said, the bubble had been rather extreme with the NGDP level rising to more than 40% above the assumed “target” in 1996 and as a result the “necessary” NGDP was very large. That said, the NGDP “gap” would never have become this large if there had been a NGDP target in place to begin with.

My conclusion is that NGDP targeting is not a policy only for crisis, but it is certainly also a policy that significantly reduces the risk of bubbles. So when some argue that NGDP targeting increases the risks of bubble the answer from Market Monetarists must be that we likely would not have seen a Thai boom-bust if the Thai central bank had had NGDP target in the 1990s.

No balance sheet recession in Thailand – despite a massive bubble

It is often being argued that the global economy is heading for a “New Normal” – a period of low trend-growth – caused by a “balance sheet” recession as the world goes through a necessary deleveraging. I am very sceptical about this and have commented on it before and I think that Thai experience shows pretty clearly that we a long-term balance sheet recession will have to follow after a bubble comes to an end. Hence, even though we saw significant demand deflation in Thailand after the bubble busted NGDP never fell below the pre-boom NGDP trend. This is pretty remarkable when the situation is compared to what we saw in Europe and the US in 2008-9 where NGDP was allowed to drop well below the early trend and in that regard it should be noted that Thai boom was far more extreme that was the case in the US or Europe for that matter.

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