In a recent tweet, George Selgin pushes back against the view that the Fed creates asset price bubbles that persist for more than a decade. But then why do these theories keep finding support?
The basic problem in economics, especially in macroeconomics, is that people tend to believe what seems plausible, not the view supported by scientific theory and evidence. The field is so complex that many interpretations are possible. This is why macroeconomics is cyclical, much like many of the arts, or like the hemline of women’s dresses. Theories go in and out of fashion for one simple reason—their plausibility varies with the state of current events.
There are three true facts that give the hypothesis of Fed created asset price bubbles a superficial plausibility:
1. Over the very short run, the Fed controls short-term interest rates via monetary policy.
2. When the Fed cuts its interest rate target, asset prices often rise immediately on the news.
3. Market interest rates have been trending lower for more than 40 years, and asset prices have risen sharply.
An average person looking at those three true facts might be inclined to reason as follows:
“The Fed has been reducing interest rates on and off for 40 years. We know that asset prices rise when the Fed reduces interest rates. Asset prices have rising sharply in recent years, far faster than the overall rate of inflation. Hence asset price bubbles are being created by expansionary Fed policy.”
Here’s why this view is a cognitive illusion:
1. Real interest rates have been trending lower for 40 years for reasons essentially unrelated to monetary policy. The Fed has cut its target rate in response to falling equilibrium interest rates. It’s a follower, not a leader. If that were not the case, inflation would have been accelerating over the past 40 years. There is absolutely no mechanism by which money can “go into” asset markets but not goods and services markets. Monetary policy is either inflationary, or it isn’t.
[BTW, money doesn’t actually “go into” markets, it goes through them. For instance, did lots of money “go into” the stock market on October 19, 1987, when stocks crashed by 22% on record volume?]
2. When the Fed cuts its target short-term interest rate by more than expected, long-term real interest rates sometimes rise. But even in those cases, stock prices often rise sharply (for instance, on January 3, 2001.) The mostly likely explanation is that both stock prices and long-term real interest rates rose on expectations that monetary easing would lead to higher economic growth.
These facts lead to a situation where people are especially likely to see imaginary “bubbles” after long periods of a depressed economy—a cognitive illusion. During these periods, news of monetary stimulus may boost asset prices for reasons essentially unrelated to lower interest rates—expectations of faster growth. Interest rates become a mere epiphenomenon. At the same time, “secular stagnation” leads to lower equilibrium real interest rates, which means future expected rents and dividends are discounted at a lower rate. That makes the equilibrium level of house and stock prices unusually high relative to rents and dividends, looking to the average person like a “bubble”.
Many years ago, I predicted that people in the 21st century would be obsessed with “bubbles”, a topic hardly even mentioned by economists during the first 30 years of my life (1955-85). It’s an endless battle, because most people will always go with the view that is intuitively plausible.
HT: Patrick Horan
READER COMMENTS
MIchael Sandifer
Feb 1 2022 at 11:11pm
The case of Japan illustrates your points well. Interest rates fell over time as a result of tight money and an aging population, and stocks and residential real estate values tanked. Interest rates are not a primary causal factor in macroeconomics.
NGDP growth is the variable that matters, and standard asset valuation equations should be changed to reflect this fact. Using such an approach eliminates much confusion.
By the way, using this approach, I’m distressed to find that the expected mean NGDP growth path, as revealed by changes in stock prices and bond yields, for the US is disappointingly low, being not much above 4%. This strongly supports the secular stagnation view, one that I’ve thought was overblown. I may have to revise my perspective.
John Hall
Feb 2 2022 at 8:28am
George Selgin is great, but I wish he would put all of what he puts on twitter onto a blog instead (i.e., something separate and different from the article-length stuff he is doing at alt-m, less polished than that). It is so much harder read and follow twitter.
Mark Brophy
Feb 2 2022 at 3:46pm
Twitter is useless and should be boycotted.
Knut P. Heen
Feb 2 2022 at 10:34am
I believe strongly in the efficient market hypothesis, but I am open to the possibility that inflation hits financial assets before consumer goods. The point is that if a central bank prints money and buy financial assets, the investors who previously owned those financial assets now own cash. What do they do with the cash? They cannot spend it all on consumer goods, it’s their savings. Until new financial assets are created (stocks or bonds issues to finance new projects), the cash is chasing a reduced number of financial assets because the central bank has removed some from the market. It is difficult to believe that supply and demand play no role in the financial markets. I believe it is true for individual stocks and bonds (financial assets are almost perfect substitutes), but not for the entire market. At some point, the private sector will start issuing new financial assets and the asset prices come down again. I guess this process may look like a bubble, but it is difficult to believe that it may last for more than a decade.
Scott Sumner
Feb 2 2022 at 1:01pm
Knut, You said:
“I believe strongly in the efficient market hypothesis, but I am open to the possibility that inflation hits financial assets before consumer goods.”
That’s right, as goods prices are sticky. But within a year you’d get the inflation showing up in goods as well.
Mark Brophy
Feb 2 2022 at 3:50pm
People believe that the Fed creates asset bubbles because the money supply and asset prices have increased sharply without a corresponding increase in economic output. You could claim that Nevada real estate is skyrocketing because it’s a better place to live than California but it’s much harder to justify increases in the price of all assets.
Scott Sumner
Feb 2 2022 at 6:39pm
Actually it’s easy—the long run decline in real interest rates, which is due to factors other than monetary policy
vince
Feb 2 2022 at 11:50pm
The Fed’s balance sheet in ten years goes from 3 trillion to 9 trillion. It’s buying financial assets. The S&P goes from about 1300 to 4700. Looks like a link to me.
vince
Feb 3 2022 at 12:03am
That period at first coincides with the term of Fed Chair William McChesney Martin, who was quoted as saying it was the job of the Fed to take away the punch bowl as the party gets going. He quit in 1970. Then inflation took off.
Scott Sumner
Feb 3 2022 at 12:07pm
Inflation took off before Martin quit. He started the Great Inflation with recklessly expansionary monetary policies in the late 1960s.
vince
Feb 3 2022 at 12:53pm
But he opposed LBJ in 1965 by raising the discount rate, and he resigned after disagreeing with Nixon on inflation. The prime rate increased from 5% in 1965 to 8.5 when he left in 1969. At the end of 1970 it was down to 6.75.
Comments are closed.