Fed Policy Too Expansive on Its Own Terms

In an interesting Brookings Institution paper (hat tip Greg Ip at the WSJ Economics Blog), former Federal Reserve economist Douglas Elmendorf looks at the question of whether monetary policy in the run-up to the credit contraction was too loose. However, he argues that the impact wasn’t great enough to have caused the housing bubble:

Let us review recent history using the predictions of FOMC members cited in the semiannual Monetary Policy Report to Congress. Between 2004 and 2007, core inflation consistently turned out higher than the FOMC had expected . One important cause was probably the passthrough of rising oil prices. But this supply shock was not the only problem: The unemployment rate came in consistently below FOMC members’ forecasts, implying that resource utilization exceeded the FOMC’s intentions. One clue to the source of this overshooting is that growth of real GDP regularly fell short of FOMC projections during this period (figure 3). In combination with the unemployment-rate surprise, we can surmise that FOMC members expected faster growth of potential output than actually occurred.

Although these charts imply that the Federal Reserve did not achieve a perfect soft landing, the errors to date have been quite small. Suppose that the FOMC began raising the target federal funds rate in April 2004 (rather than June 2004 as actually occurred) and raised it 25 basis points in each meeting for the next two years (as did actually occur). In this alternative scenario, the funds rate would have been 50 basis points higher from the third quarter of 2004 through the second quarter of 2006. Based on simulations of the Fed’s large-scale econometric model (reported by Reifschneider, Tetlow, and Williams, 1999), this less-expansionary policy stance would have added about 0.4 percentage point to the unemployment rate and trimmed 0.3 percentage point from the inflation rate by mid-2006. Thus, the unemployment rate would have been close to 5 percent—which is apparently what FOMC members view as the NAIRU, because their projections show the unemployment rate heading back to 5 percent (from above in 2004 and 2005, and from below in late 2006 and 2007). In addition, the inflation rate would have been about 2 percent, which many observers view as the upper end of the Fed’s comfort zone. Thus, from the perspective of the overall economy, this slightly tighter policy stance would have produced a better outcome to date.

What would have been the effect on the housing market? Because such phenomena are matters of psychology as well as economics, this question is difficult to answer. Alan Greenspan and others have argued that small adjustments to financial conditions cannot “defuse a bubble.” On the other hand, perhaps the extra tightening described here would have been the straw that broke the camel’s back early. My guess is that this small adjustment in policy would have only slightly damped the courses of construction, house prices, and mortgage lending.

Note that Elmendorf first works through the data: the Fed somewhat overshot its inflation target and in retrospect it appears to have overestimated the economy’s growth potential. He then notes the degree of error wasn’t large and doesn’t seem to have been enough to have set off the housing price run=up.

The problem with analyzing what happened in a period of time this short is that there aren’t enough data points to have a great deal of certainty about any conclusion. Elmendorf ‘s point of view is certainly reasonable.

But consider another argument. If you believe the labor-driven deflation theory that Greenspan pushed in his new book, namely, that the world has had the benefit of cost deflation due to increased use of lower-cost labor in emerging markets, that would operate as a short-term offset to any inflationary pressures. And in recent years, the jobs threatened by outsourcing and offshoring aren’t just factory workers but increasingly white collar workers and even professionals. That degree of employment insecurity just about eliminates any bargaining power that labor might have. So if you subscribe to that view, Fed policy was even more expansive than the raw figures suggest.

And a bone of contention: Elmendorf cites Greenspan saying, “small adjustments to financial conditions cannot “defuse a bubble.'” That’s incorrect. Ian MacFarlane the Governor of the Reserve Bank of Australia, did unwind a much larger housing bubble (an index of housing prices in the Economist in 2005 estimated that its prices had risen twice as fast as those in the US from 1997 to 2005 and that the its value of home prices to rents was similarly even higher than the long-term relationship).

Admittedly, anyone who had any sense knew the Australian market was toppy so MacFarlane may simply have had spectacularly good timing. Nevertheless, he used a large dose of moral suasion and a coupe of rate increases and housing prices fell, but not so rapidly that they took the economy down with them. By contrast, since Paul Volcker, our Fed chairmen have been unwilling to put their reputations on the line.