Policy Shift: Can the Fed Identify & Pop Asset Bubbles?
Interesting discussion in the FT Wednesday about a potential major shift in Fed philosophy: Maybe its a bad idea for Central Banks to passively wait for bubbles to pop.
I am not sure if the Fed will shift away from the Greenspan doctrine: "Inflate Bubbles & Clean Up he Mes After." Will the change be to something less disruptive, or will they throttle the growth side of the equation? That's the risk.
Perhaps one idea worth exploring might be not to not blow these bubbles in the first place.
Here's an excerpt from the FT:
"The US Federal Reserve is reconsidering the way it deals with asset price bubbles in the wake of the housing and credit bust, in a move that could see the central bank using regulation - or even interest rates - to fight unjustified increases.
Top officials are re-examining the Alan Greenspan doctrine that central banks should not try to tackle asset bubbles and should focus on mitigating the fallout when they burst.
They are open to the possibility that the Fed may have to adopt a different strategy in future. However, they have not reached any conclusions and could end up reaffirming their traditional hands-off stance . . .
The Fed has long stood out among central banks as the least willing to embrace the idea that it should "lean against the wind" when asset prices are rising rapidly. Former chairman Mr Greenspan famously argued that it was in practice impossible to identify bubbles before they burst, and attempts to prick them by raising rates were likely to do more harm than good."
Greenspan has claimed its impossible to identify bubbles in real time; Ben Bernanke has been more contemplative on the subject. He's said its "difficult" to know for sure when we are n a bubble.
Chairman, let me suggest a few data points worth considering:
• Standard Price Deviations: Is the asset class trading 2 to 3 standard deviations away from its traditional price metrics?
• Inventory: Is there a huge inventory build? Bubbles create the incentive to produce a whole lot more, be it Miami condos or dot com companies.
• Fundamentals: Has something shifted in the fundamental supply/demand equation that is impacting pricers, or is it pure speculation?
• Regulatory Changes: Has the government altered some part of the equation that might have changed the game somewhat?
There are others, but these are a good beginning.
Note that the inventory metric is why I have doubted commodities are a bubble; also I have long claimed that we did not have a national Housing bubble, but instead had a lending & credit bubble -- a subtle but important distinction.
By the same metrics, I agree with I agree Stuart Hoffman, chief economist of PNC Financial, who notes that the enormous volume of new condos in Miami in inventory are just that proof of a local bubble (I agree).
>
UPDATE: May 16, 2008 5:42am
WSJ:
First came the tech-stock bubble. Then there were bubbles in housing and credit. Chinese stocks took off like a rocket. Now, as prices soar on every material from oil to corn, some suggest there's a bubble in commodities.
But how and why do bubbles form? Economists traditionally haven't offered much insight. From World War II till the mid-1990s, there weren't many U.S. investing manias for them to look at. The study of bubbles was left to economic historians sifting through musty records of 17th-century Dutch tulip-bulb prices and the like.
The dot-com boom began to change that. "You were seeing live, in action, the unfolding of lots of examples of valuations disconnecting from fundamentals," says Princeton economist Harrison Hong. Now, the study of financial bubbles is hot.
Fed should deflate some bubbles, Mishkin says
The Federal Reserve should try to aggressively deflate some types of asset bubbles before they can harm the economy, Fed Gov. Frederic Mishkin said Thursday.
But raising interest rates isn't the way to prick a bubble, he said. And some types of bubbles, such as the dot-com bubble of the late 1990s, probably shouldn't be pricked at all, he said.
On the other hand, the housing bubble of this decade was the type of bubble that should have been targeted with closer supervision and tighter regulation to prevent widespread economic damage, Mishkin said.
The Fed should watch for bubbles that are associated with a fast expansion of credit, he said, because these bubbles have the potential to inflate bank balance sheets on the way up and destroy them on the way down.
>
Sources:
Fed looks at ways to fight asset bubbles
Krishna Guha
FT, Tuesday May 13 2008 18:05
http://us.ft.com/ftgateway/superpage.ft?news_id=fto051320081916203957
Bernanke's Bubble Laboratory
Princeton Protégés of Fed Chief Study
the Economics of Manias
JUSTIN LAHART
WSJ, May 16, 2008; Page A1
http://online.wsj.com/article/SB121089412378097011.html
Fed should deflate some bubbles, Mishkin says
Monetary policy ineffective, but supervision can break harmful feedback loops
Rex Nutting
MarketWatch, 7:04 p.m. EDT May 15, 2008
http://tinyurl.com/4wk673
Thursday, May 15, 2008 | 06:45 AM | Permalink
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Comments
What's the biggest bubble to pop with this change in Alan Greenspan's only contribution to Central Bank thinking? Greenspan's un-deserved reputation for competence.
Now that's over with move on and defend the currency.
Posted by: VennData | May 15, 2008 7:05:17 AM
The Fed should examine its very reason for existence -- the premise that central planning of credit expansion can add economic value. I believe that is flatly false.
Do us all a favor, Ben -- declare victory, fold tents, and march home. Thanks in advance, buddy.
Posted by: Jim Haygood | May 15, 2008 7:12:45 AM
Now that we've had bubbles in RE, stocks, commodities, credit, emerging markets and treasuries; I think what the Fed is really trying to say, in its own perfect contrarian kind of way (ie "energy prices will moderate") is that there is nothing left to have a bubble in. So sad.
Posted by: RichardN | May 15, 2008 7:21:56 AM
i don't see this happening b/c the basis for all their actions is that the free market is this all-knowing spectre that reflects all information.
if the market says a shanty house in florida is worth $700k, then it's worth $700k.
but common sense would say this is nonsense, but the free market says otherwise & is always right.
Posted by: m3 | May 15, 2008 7:43:20 AM
M3,
The market is just other people.
If you can disagree with your wife about how much to spend on a car, or a house you can easily disagree with 5 million other investors. the question is not whether the price is right, but whether it is right for YOU. If you disagree with what shanties in Florida's are going for don't buy! If you think that the bank charges too much interest, don't ask for credit!
Bernanke, on the other hand, wants to decide prices for you.
Posted by: joe | May 15, 2008 7:50:38 AM
BR said
Note that the inventory metric is why I have doubted commodities are a bubble
Reply: Given the way commodities are sold - via exchanges and contracts - and also given there is no competitive reason for anyone other than the end user to oppose higher prices, the inventory model for bubbles does not apply. The oceans of money flowing into this arena, none of which have any reason to want lower prices, invalidate your cause and effect assumption.
Having said that, I would liken commodity price increases more to price fixing than to asset bubbles. Instead of a few people colluding in a small room or via email about cornering a market for widgets, big money is only constrained by it's nerve in how fast to bid prices up, inviting other market participants along for the ride. There are no economic forces in play or available that could influence prices down. If one or more exist, please enumerate.
The Hunt brothers tries to corner silver a couple of decades ago. Their mistake was not including all market participants into their scheme. Prices would have risen and nobody would have done anything to stop it.
Posted by: cinefoz | May 15, 2008 8:02:32 AM
The models you need to predict an asset bubble in a subprime market post-FASB 157 are so simple that even undergraduate electrical engineers could have come up for some estimates for when the bubble would burst.
If regulating price means avoiding things like FASB 157, it seems unambiguous that the Fed should take a larger role.
In other news, aren't Berkshire-Hathaways long-term puts another way to avoid bubbles that doesn't require gov't regulation?
Posted by: Michael F. Martin | May 15, 2008 8:10:25 AM
Cinefoz, well said.
Posted by: JustinTheSkeptic | May 15, 2008 8:10:50 AM
$700k shanties in Florida were not a result of a "free market." This aberration was produced by non-free market factors such as rapid currency depreciation and government-sponsored housing credit.
During the gold-standard years from 1871 to 1900, real estate had a reputation as an asset that always declined in price. Since the advent of paper money in 1913, and GSE-subsidized mortgages in the postwar era, real estate has been systematically overvalued because it serves as an inflation hedge, though an imperfect one.
Posted by: Jim Haygood | May 15, 2008 8:11:49 AM
Good job Jim...when I told the chief economist of a major investment firm 6 years ago that the Fed should be abolished, he looked at me like I had 7 heads. It's ingrained in them all by now.
Posted by: Steve Barry | May 15, 2008 8:25:29 AM
cinefoz ..excellent comment...I'd add the emotional environmental brainwash playing right into the manipulation..
Posted by: brasil | May 15, 2008 8:29:55 AM
I do not see any possibility that the Fed can micrmanage to that degree - or any other government agency.
However, the Fed should recognize that there is a normal cost of doing business and that money must have value - to have maintained the free-for-all during the house price run up was irresponsible. You cannot just give it all away and build a functioning economy. The Fed needs to target a rate that long-term experience says is workable and then get there as fast as possible. Any deviation should be very short term. Business cycles should be recognized and accepted.
Posted by: wally | May 15, 2008 8:42:25 AM
Steve Barry,
If oil and other commodities were not being priced at such stratospheric levels, I would be patiently waiting for S&P 1500 and beyond. The economy would grow slowly out of it's other troubles.
Given the pervasiveness of this organized crime and the bewildering tolerance for it by environmental idiots, there is no reason for the economy to grow and every reason for it to stagflate. Thus, my pessimism at this time.
Posted by: cinefoz | May 15, 2008 8:45:37 AM
To play devil's advocate on commodities, most are 2 to 3 standard deviations from their long-term price bands, especially oil (our fund runs regressions). I struggle with whether this means it is a bubble as well, although it certainly indicates the asset class is not undervalued.
Posted by: Ben Gordon | May 15, 2008 8:57:32 AM
"Perhaps one idea worth exploring might be not to not blow these bubbles in the first place"
The bubbles inflate spontaneously in the market when the conditions are right. Anything the fed can do is at most just a part of those conditions. The fed doesn't blow bubbles. If that were so, anytime they lower the interest rate a bubble should pop up somewhere.
I'm afraid it's not that simple. What could the fed do to stop the dot.com bubble from materialising? Investment world was full of enthusiasts who expected to gain 100% in half a year. They would not have cared if fed funds were at 15% - as opposed to the rest of the economy.
As far as I know, bubbles have been around for much longer than the fed. Who was inflating them when there were no central banks? You can't blame the fed for something that happened in the 17th century.
So face it, there will be plenty of bubbles coming along in the future, no matter what Ben decides to do. Human nature will remain unaffected by the short term interest rates, as well as by regulation.
Posted by: gv | May 15, 2008 8:58:27 AM
I agree with wally "the Fed should recognize that there is a normal cost of doing business and that money must have value - to have maintained the free-for-all during the house price run up was irresponsible"
The FED hyperdrove this economy for the 2000 to 2012 players at the expense of the future players. A cash power grab via derivatives. Creating a Wall Street Power Base of MUST play the game or loose out.
I am ticked that pure stash cash in a bank savings pays next ta nothing. I am ticked cash pile pushing is a job, and beyond that, seemingly a well paying job.
Posted by: Greg0658 | May 15, 2008 9:06:15 AM
"To play devil's advocate on commodities, most are 2 to 3 standard deviations from their long-term price bands, especially oil (our fund runs regressions). I struggle with whether this means it is a bubble as well, although it certainly indicates the asset class is not undervalued."
Long-term price bands assume a fairly consistent demand/supply relationship. For commodities, especially oil, that is now changing, in a secular fashion, for the long-term.
Posted by: Mind | May 15, 2008 9:19:46 AM
cinefoz....i hope u did not convert into a bear two months back..
because your bullish strategy seems to be working fine, even though it does not make sense what has changed in the past two months that many stocks are back to their 52 week high levels...(AAPL, RIMM etc..)
Posted by: techy | May 15, 2008 9:35:37 AM
techy,
I bought in early enough to be in position to make money ytd several weeks ago. I 'pressed the button' and cashed out. I underestimated the emotional need for this market to continue going up even if it had no logical reason. Oil rising to $115 with conviction spooked me. Given the market at that time was oscillating at a plus / minus level for my situation, I decided to take my profits and wait for the next cycle.
I firmly detest having to make the same profit twice by not selling on a timely basis. I'd rather take a smaller profit than risk a loss. I call this a maximize the minimum gain strategy. If oil had not risen so aggressively, I would have waited until I saw a huge fall in the morning markets, such as those last November.
I think it is trading at a peak level now and will fall at some point in the near term. The bullish sentiment by the idiots now in the market will, hopefully, cause the next dip to be a quick one. I think it will drop to near January lows, but turn quickly. I'll probably make 3 buys around that time, just to spread the timing risk.
Posted by: cinefoz | May 15, 2008 9:54:22 AM
It's not very hard to identify bubbles. The only way you can have a bubble is if people are borrowing to buy something. The Fed can prevent bubbles by monitoring the overall leverage in asset classes. If they start noticing the leverage increasing too quickly, they can reregulate banks to reduce the amount of leverage available to the markets.
The Fed could have prevented the housing bubble by forcing banks (and MBS writers) to only count mortgages as assets up to 80% of the home's value. Very few banks would have been willing to write a 100% mortgage if it meant they had to book a 20% loss as soon as they wrote the note. The dot-com bubble would not have happened if stock margin requirements had been increased in 1999 (they were increased after the bubble had burst instead). It isn't clear if oil is a bubble or not, but if it is the Fed could pop it by upping the margin requirement to 70% or higher for everyone who doesn't take delivery on at least 2/3 of their futures contracts. That would cut out most of the speculators, leaving only the refiners and suppliers as the major market movers.
Interest rates are a very crude tool. If you are going to target bubbles, you have to do it more directly.
Posted by: jkw | May 15, 2008 10:05:17 AM
BTW, late this year, if oil does not correct, I expect to see a whole new level of low in the stock market. Reality will catch up, eventually. It might drop to mid 2006 levels.
Posted by: cinefoz | May 15, 2008 10:09:37 AM
Well, with the rise in unemploymentapplications again today, and the decline in manufacturing (another .7%, second .7% decline in 3 months) even the loudest bulls will have to realize that the housing crisis and energy costs will stop the growth of the economy here...and yesterday real wages were reported as dropping .5%...there is nothing I can see that wouldn't make me want to just sit awhile and see where this is heading....
Posted by: Bruce | May 15, 2008 10:13:57 AM
No matter what metrics they might use they would never raise interest rates or take other action to restrict credit expansion in a timely fashion. As Mises pointed out years ago it's tantamount to admitting the "prosperity" they had been taking credit for was a fraud, and taking any action to pop a bubble means they will get blamed for the aftermath. It's always easier to find a new era excuse to justify letting it rip.
Posted by: just dug | May 15, 2008 10:22:38 AM
One more item for the list
It is NOT different this time!
On a more serious note.
I am not sure that all the blame rests with the regulatory bodies. There is also a cultural component.
Our leadership has has a somewhat wild west kind of attitude and there has been an unusual lack of anger. There has never been a push by the masses towards making our leaders and regulators accountable.
Posted by: Ralph | May 15, 2008 10:27:44 AM
You can't miss bubbles. Monetary flows (MVt) is infallable. Anyone that wants to know how to do it can go to:
http://fraser.stlouisfed.org/publications/bms/issue/61/download/125/section5.pdf
Posted by: flow5 | May 15, 2008 11:16:08 AM
