I recently spoke with some very smart people who work in the financial industry, and encountered a widely held view that asset bubbles are created by easy money policies. I think that view is wrong, but first let me acknowledge that there is a great deal of evidence in favor of that hypothesis:
1. In recent years, asset prices have often been unusually high by historical standards.
2. In recent years, the Fed has often adopted a low interest rate policy, with QE.
3. Event studies show that monetary easing announcements often increase asset prices.
4. Fed officials have cited asset prices as one of the ways that monetary stimulus can help during a depressed economy.
Put all that together and it sure looks like easy money is artificially inflating asset bubbles. However, I believe there is a better explanation for this set of facts.
First, let’s assume that basic economic theory is correct, and that the long run downtrend in (long-term) real interest rates is not caused by easy money, rather it reflects changes in the global economy related to saving rates in Asia, demographics, declining investment in traditional (capital intensive) industries, less construction of infrastructure, etc. Theory suggests that monetary policy does not determine long-term real interest rates.
Second, assume that assets are more valuable in a booming economy with high earnings than in a depressed economy. Then one can describe 4 states of the world:
1. High real interest rates, weak economy (early 1980s)
2. High real interest rates, strong economy (late 1980s)
3. Low real interest rates, weak economy (2002, 2009)
4. Low real interest rates, strong economy (today)
Think of the 20th century as a high real interest rate century and the 21st century as a low real interest rate century. Low asset prices occur in state #1, such as the early 1980s, medium asset prices occur in states #2 and #3, and high asset prices occur when real interest rates are low and the economy is booming, as is the case today.
In my hypothesis, monetary stimulus announcements do not boost asset prices by reducing long-term real interest rates, rather they increase the probability that the economy will be in the prosperous state going forward, not the depressed state. Another part of my hypothesis is that money has not been as “easy” during the 21st century as widely perceived, rather the low rates and QE policies mostly reflect defensive maneuvers to deal with the low interest rate environment caused by unusually low NGDP growth rates. Actual periods of extremely easy money (i.e. 1965-81) were not associated with asset bubbles.
My hypothesis has several advantages over the standard view:
1. The standard view is that the sharp fall in asset prices during 2007-09 was a sort of “correction” from bubble levels. My view predicts that asset prices would rise again to what look like inflated levels after the economy recovered. They have.
2. The standard view is that money has been easy throughout much of the 21st century. My view explains why we have not had the price inflation normally associated with easy money. The low interest rates and QE are misleading, and the stance of monetary policy is better described by NGDP growth rates.
3. The Fed’s attempt to restrain the stock market boom during 1928-29 failed until rates got so high (in September 1929) that they drove the entire economy into depression. Real rates rose to 7%. There was no monetary policy stance capable of popping an asset bubble without tanking the economy. The Fed has never again repeated this “experiment”.
Asset markets respond positively to easy money announcements that make a “bad economy” scenario less likely, which is 100% consistent with an efficient markets world with no irrational bubbles.
READER COMMENTS
Mikko2
Jun 7 2019 at 2:07pm
>money has not been as “easy”
I wonder what would the easy money look like? Just significantly more of the same means that have been used already (subzero interest rates, buying stocks, QE, …)?
>easy money announcements .. make a “bad economy” scenario less likely
Easy money improves economy, okay. Is there a limit for this: can money be too easy in the world painted above. How do you know if money is or has been too easy?
Scott Sumner
Jun 8 2019 at 12:10pm
Mikko, Look at NGDP growth expectations. Faster growth means easier money. I.e., growth in M*V.
Thaomas
Jun 9 2019 at 6:25am
Wrong question. What policies move the average price level up and or the use of real resources (for which the unemployment rate is not the best indicator) up or expectations of the same?
Matthew Waters
Jun 7 2019 at 7:56pm
If nothing else, when people say “the Fed’s easy money is inflating asset prices,” what’s the alternative? The Fed not reducing rates and creating a Great Depression?
Matthias Görgens
Jun 7 2019 at 10:34pm
I think they are hoping for an alternative of low-ish asset prices and moderate stable commodity price inflation.
They don’t need to share the view that those two might exclude each other when they are hoping.
Hey, simple people think that the main problems the economy or even the world is facing are just the doings of some easy to identify bad people. And if we could stop the bad people, everything would be splendid.
Brian Donohue
Jun 8 2019 at 3:38pm
Excellent post.
Benjamin Cole
Jun 9 2019 at 8:15pm
Regarding asset prices in the United States, the IMF has posited that large capital inflows, born axiomatically from large current-account trade deficits, are bloating asset values—- indeed, the globalist IMF has posited that a Hyman Minsky moment could result in what they term as “financial instability” ( what Ordinary People call “a bust”).
Who knows? The United States is now running a current-account trade deficit of about $600 billion a year, which is smaller in relation to GDP than in the 2007 era. But that $600 billion a year has to be invested somehow, whether in stocks, bonds, or property.
One could also posit that US asset owners are somewhat addicted to foreign capital inflows. The brokerage class eagerly arranges transactions, and asset owners are happy for the resulting inflated values. Does this explain the establishment embrace of large and chronic current-account trade deficits?
Thaomas
Jun 10 2019 at 6:33am
Good point except I think you have the causation wrong about trade deficits causing the capital inflow. (Perhaps I misinterpret you and if so sorry, but I’ve hear others make that mistake.) I’d trace some of the capital inflow to the structural deficit in the Federal budget that even with average inflation targeting means (and more so with an inflation ceiling) that the Fed has to keep interest rates higher than otherwise.
Arthur Eckart
Jun 10 2019 at 5:34am
The asset bubble of the late ‘90s coincided with strong disinflationary or non-inflationary growth.
The 2001-07 expansion was built upon strong economic growth in 1982-00 and the mild 2001 recession.
Congress created the asset bubble(s) in the mid-2000s through its policy of increasingly more “affordable” home loans.
Arthur Eckart
Jun 10 2019 at 7:14am
I’m not sure we’ve had “easy” money from the Fed.
I think, we’ve had “jawboning” to keep inflation expectations low and close to appropriate monetary policy.
The 1965-82 period was a structural bear stock market and 1973-82 was a long-wave bust cycle. Without the perceived “easy” money by the Fed, real GDP may have been worse.
Arthur Eckart
Jun 10 2019 at 7:27am
The “recovery,” since 2009 has been very slow. The output gap still hasn’t closed or full employment hasn’t been reached.
The Fed Funds Rate should be cut this month. And, slow or stop bonds from maturing without replacing them on the Fed’s balance sheet. Monetary policy is not “easy.”
Scott Sumner
Jun 10 2019 at 12:45pm
I agree that rates should be cut, but not because we are not at full employment. Economists don’t know the precise level that represents of full employment. Better to focus on other variables when the unemployment rate is 3.6%.
milljas
Jun 10 2019 at 1:12pm
I’d be curious what types of investors these were and how sophisticated. I found the Beckworth and Lonengran interview, along with the one with Darda from long ago, quite refreshing in that these are market participants that seem to grasp monetary policy and the functioning of markets. Most participants that I encounter unfortunately share the view you describe: bubbles are everywhere, a recession is due, low rates means easy money, rates are too low, asset prices are wildly high. It’s all the Fed’s fault. Yet they don’t seem to piece together that their Starbucks habit barely costs more than 10 years ago. Similarly, I’d be shocked to meet an equity portfolio manager that has heard of, never mind read, something like Friedman’s 1968 address or anything from the likes of Leland Yeager, nevermind Earl Thompson.
I find that constantly encountering market participants that don’t get the markets in the way that you or Lonengran or John Cochrane (his Monetary heresies post) do is a strange phenomenon. How can the markets be right, when so many participants seem to be clueless? I must not hang out in the right circles. My firm did pay MKM/Darda but not anymore.
So, it’s odd you commented on this Cochrane post. I’d be curious how you interpret the other one he recently put up where the market seems to consistently forecast the fed funds futures rate incorrectly.
https://johnhcochrane.blogspot.com/2019/06/futures-forecasts.html
Scott Sumner
Jun 11 2019 at 3:47pm
milljas, You asked:
“How can the markets be right, when so many participants seem to be clueless?”
How can a human brain be so intelligent when each brain cell, taken in isolation, is so dumb? It’s the “wisdom of crowds”.
milljas
Jun 12 2019 at 10:45am
I understand that individuals in the market are wrong and there is some magic to how things come together – I’m listening to Russ Roberts dicussions on “emergent order”. Still, you’d think that after 15 years I’d encounter someone that gets it. I think it has to do with the weighting of individual agents in that the person that manages Bill Gates Wealth or the Norwegian Sovereign wealth fund would matter more than say Jeremy Grantham at GMO or Howard Marks at Oaktree or worse John Hussman or some other Ivy educated mickey mouse hedge fund manager that gets famous from one lucky call.
More to the point, John’s post refers to how the market for the fed funds rate has been consistently wrong over the last 10 years. Basically this makes me wonder why your NGDP futures market system would work if the current fed funds market – one that’s already live – has done a poor job of predicting the path of the fed funds rate. Perhaps there are technical issues with that market which don’t make it a good forerunner for your system, I admit I haven’t gone through his three points at the end.
Greg Jaxon
Jun 10 2019 at 2:10pm
The words “inflate”, “bubble”, and “easy money” are part of political rhetoric; they are used in support of a overly-simplified narrative about how US legal tender is the world’s “money.” Every red-blooded American fills with pride edged with anxiety for this supposed commercial (and almost-imperial) leg-up. But further talk about this political fiction is just posturing and vying for a seat among the central planning cadres.
Capital assets are like financial assets (bonds) in having a (dividend) yield that will (all-else-equal) vary inversely with price. Even Keynes believed that the long term interest rate is bounded from above by the long term rate of return on capital. At any rate it is easy to imagine the arbitrage of the marginal holders of capital and bonds keeping the two sources of yield in close correlation.
You’re correct to say that “the Fed” doesn’t directly control “the interest rate” (and I can recall when it was supposedly controlling the “discount rate”), but you’re wrong to say that no valid theory relates these things. We have a vast and complex financial industry founded on the principle of “borrowing short to lend long” and so betting its livelihood that the yield curve never inverts for too long. It is this industry which creates the bulk of the “circulating” dollar units, and its livelihood which will have the most impact on whether its primary product is perceived as tight or easy.
That said, I don’t know how you can exonerate the Fed with this “the dog ate my homework” excuse given that the homework was to make dog food. An FOMC buy operation (especially those pre-announced, or predictably implemented under certain rules) must raise the bid on whatever bond is bought, and this must lower that bond’s yield. Wherever that bill or bond sits on the duration axis, the finance industry will work to propagate the signal around the yield curve. What you call “good economic times” is really a yield curve that keeps those duration bets solvent. NGDP growth is just a palatable name for being able to keep up against the bookmaker’s fee for writing all this credit.
The expressed intent of the 2008 bailout & QE was to re-capitalize banks and throw them a profitable operating curve for their duration-mismatch game. Other acts (specifically the insuring of money market funds) monetized other kinds of assets so that the taxpayers were effectively underwriting the liquidity of many industries and individuals. Socializing these potential losses was pure central planning. Before you simply agree and step into the role of assistant central planner, can you please explain how the small cadre of planners is going to out-think the great masses of economic actors by only using government-collected statistics? That sounds like sugar coating a Great Leap Forward (Green Leap Forward?) The numbers worked while millions starved.
There was, is, and will be an organic money that is not US legal tender and which predates and will survive the American century of empire. I think your positions would be philosophically better founded if you could relate the course of the dollar back to that enduring economic reality. Treat this “asset”-backed, but irredeemable currency for what it is: a debt-accounting scheme subject to (and fully funding) an overwhelming coercive force of an unaccountable collective.
Arthur Eckart
Jun 11 2019 at 8:56am
Other factors, e.g. wage growth, suggest we’re not at full employment or beyond full employment.
Over the 10 year period 2008-17, we added an average of 78,000 jobs per month.
However, we needed up to 159,000 jobs per month to keep up with population growth, subtracting retirements, and adding discouraged workers (or those expected to re-enter the workforce, if the “recovery” wasn’t so weak).
The conservative estimate, based on 100,000 jobs per month over the 10 year period, means we needed 2.6 million more jobs through 2017. So, at least, an additional 2.6 million jobs, above the 100,000 per month, is needed in 2018 and beyond to reach full employment.
Arthur Eckart
Jun 11 2019 at 9:03am
Although, we’d expect job growth to slow the closer we get to full employment, we’re still creating too many jobs (e.g. 12 month moving average) to be at full employment.
https://www.bls.gov/web/empsit/ceshighlights.pdf
Scott Sumner
Jun 11 2019 at 3:54pm
High rates of job growth don’t mean you are not at full employment, as we saw in the late 1960s (when we went beyond full employment.)
Arthur Eckart
Jun 11 2019 at 5:05pm
Yes, but a wartime economy is not a good comparison.
Arthur Eckart
Jun 11 2019 at 5:20pm
Also, there may have been strong job growth in the late ‘90s, when the country was beyond full employment and real wages were rising much faster.
However, the Baby-Boomers reached their peak productive years in the late ‘90s with the height of the Information Revolution.
In this expansion, we haven’t fully recovered yet. Labor is re-entering the workforce and part-time jobs have been falling.
Arthur Eckart
Jun 12 2019 at 5:24am
Do you think we’ll get an extended expansion of several more years or a mild recession, because the “recovery” has been so weak from the severe recession, to recover part of the trillions of dollars of lost output, since 2009?
It’s already the longest expansion in U.S. history. The assumption is expansions die from excesses, not old age.
Arthur Eckart
Jun 12 2019 at 5:52am
Also, have you’ve seen this perfect recession indicator:
https://www.google.com/amp/s/www.cnbc.com/amp/2019/02/20/a-recession-indicator-with-a-perfect-track-record-over-70-years-is-close-to-being-triggered.html
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