Monday, October 28, 2013

Follow Up to Real Rates & Housing Boom

This is a follow up to this post, and other previous posts on the topic.

I would also challenge the causality of the subsequent crisis.  I learned this from Scott Sumner, although I won't attribute it to him, in case I've gotten a detail wrong in my own interpretation of it that he would not agree with....

Common Interpretation
1) Low short term rates (from loose money)
2) Banking Bubble
3) Housing Bubble
4) Housing Bubble Bursts
5) Fed cuts rates in 2007-2008 in heroic attempt to throw more loose money at the problem
6) Economy collapses anyway
7) Fed continues pushing loose money at the problem, propping up a fake economy
8) All that loose money is once again inflating a housing bubble
I would say that this is totally wrong, but there are just too many subtle interpretive changes required, and the change in the paradigm caused by those interpretive changes is so marked, that it would be a difficult change for a reasonable observer to accept without some strong social support.
I don't mean to use some broad hypothetical psychoanalysis to dismiss all reactions against my interpretation.  I may seem wrong because I am actually wrong.  But, if I'm on to something, I don't think it's an argument that can be easily reasoned through.
In any case:
My Interpretation
1) Low long term inflation expectations (from tight money) together with low long term real rates.
2) Housing Boom (not bubble)
3) Banking Bubble (from a combination of the housing boom and regulatory issues)
4) Short term rates decline due to manageable declining demand, possibly assisted by home prices which were declining (still behaving reasonably in relation to long term rates)
5) Fed follows short term rates down, creating the image of loose monetary policy even though liquidity problems in the financial sector and a stagnant monetary base indicated very tight monetary policy.
6) Money becomes so tight that the economy collapses in a liquidity crisis in 2008
7) As a result of such low nominal rates, the Fed loses much of the leverage of conventional monetary policy mechanisms because there is little to no incentive to spend or lend cash that the Fed releases into the economy through bond purchases.  The large amount of bank reserves this creates continues to create a false impression of loose monetary policy even though policy continues to be fairly tight.
8) Housing boom re-ignites in the aftermath of the crisis, even as credit conditions remain tight, because the original context of low real rates and low inflation expectations remains in place.
I'm afraid that we will see #9) Fed tightens money supply in a misguided attempt to avoid a new housing bubble, causing real incomes to fall again.

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