Thursday, February 26, 2015

Housing Tax Policy, A Series: Part 15 - The Subprime Crisis and Inflation Targeting

Ok, one more graph on the timing of the crisis.  Here we can see the problem of inflation targeting.

There has been some discussion about how commodity prices bumped up in 2007 & 2008, which caused the Fed to be too hawkish.  And, I have discussed how current inflation is negligible, but for supply-shock shelter inflation.  But, I think we can step back even further, and see this problem even earlier.

I have looked at the period around 3Q 2006, when the yield curve inverted.  But, let's look even further back, to 2Q 2006 (0b), or even 4Q 2005 (0a).  Even before the yield curve inverts, we can see that liquidity is having an effect on the housing supply.  (Remember that currency growth, which has tended to be between 7% and 10% since the 1970's, fell under 5% by 2005.)  By 4Q 2005, shelter inflation took a sharp turn upward.  This was a monetary-related supply shock.  Because everyone was so thrown off by high nominal home prices, this seems implausible.  But, if we pull shelter out of the inflation indicators, we see that non-shelter inflation collapsed by 4Q 2006, with Core CPI less Shelter falling all the way to 0.7%.  Core CPI with Shelter included was still at 2.1%!  Seemingly above target.

Keep in mind that shelter inflation takes a 3 sigma turn upward between time 0a and 0b when we look at the next graph.  (It is normally a fairly stable measure, like Core CPI is.)  While shelter inflation is soaring, home prices are stagnating and new home supply is collapsing.  How can this be interpreted as anything other than a massive supply shock?  And this all happened before 3Q 2006!  But, because the narrative of predatory, reckless banks is more believable than the mathematical relationship between yields and prices, nobody can believe this was the case.

Note here that currency growth falls in 3Q 2006 also, and will remain around 2% until 2008.  So, keeping all of these things in mind, we can think about mortgage growth, shown in this graph.  At this point, mortgage growth isn't funding new homes anymore.  It's not funding home price appreciation any more.  At this point, mortgage debt has become a source of desperation liquidity.  Mortgage levels as a percentage of home values turned up sharply by around Q1-Q2 2006.  As I showed in Part 12, this liquidity coming through mortgages between 2004 and 2007 all came from households in the top 40% of incomes.  Households in the bottom 60% of the income distribution were not increasing their outstanding mortgages during this period.

It looks to me like the Fed created its own supply-side inflation shock, then mistook that for a positive demand shock, and subsequently worsened what was already a negative demand shock.  But, can we blame the Fed when the entire country is seemingly wrong about housing?

I am hoping that I can make some inferences about tax benefits of home ownership and the relative supply of housing in later posts.


  1. The key problem with inflation targeting seems to be that when there is a (negative) supply shock (e.g., in housing in 2006), the Fed sees rising prices, and reacts by tightening money, which is the last thing you want to do when a supply shortage is forcing prices up in one sector, because all you end up doing is forcing prices down in all other sectors, nominal rigidity strikes, and ... unemployment.

    NGDPLT advocates (like you and me) feel that the Fed would be better off ignoring the price level completely and focusing only on nominal spending.

    It feels like we should be able to test the idea that targeting NGDP level is better than targeting inflation by taking actual historical data (of prices and NGDP), and looking at what would have been different if NGDP had been forced along a level-target path, assuming some Philips-curve-style relationship between output and unemployment. For example, if the Fed tightened in response to inflation, and then NGDP fell below target, we would say, what if the Fed had not tightened, NGDP had stayed on trend, and then we will allocate the additional NGDP to real growth versus price-level growth based on the level of unemployment during that period. Is this making any sense? Basically, you'd be trying to show that NGDP level targeting would tighten when the alternative was excessive employment and inflation, and would not tighten when tightening caused (real) output to drop. Of course it is also possible that the Fed sometimes tightens and NGDP falls below trend but unemployment remains low, and if the Fed had pursued NGDPLT and not tightened, the entirety of NGDP growth would be price level growth. It would be interesting to know.

    Do you think this sort of investigation would make any sense? Do you think we have the data to do this?


    1. Hm. I think it may be more difficult than that. I think the first order effect would be that there would be more inflation, not more real GDP. The relationship leading to the subsequent drop in real GDP gets more complicated. I think it would be tough to do. Though, if you could do something like that, it would be interesting.

    2. Okay, thanks Kevin. Always looking for ways to build the case for NGDPLT.

    3. Okay, thanks Kevin. Always looking for ways to build the case for NGDPLT.