On Wednesday, Alan Greenspan, former maestro, exculpated himself from blame for the Mess We’re In in a WSJ editorial.
David Merkel at the Aleph blog, and ourselves here (less maestro, more ingénue), had a few holes to poke in former Fed chairman’s rationale. Here’s what Greenspan wrote:
There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess.
The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.
The argument being that essentially, the Fed’s policy actions through the noughties did not influence the US housing market. As Greenspan goes on to state (emphasis ours):
…the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.
In response to which, we reprise this excellent paper by John Taylor – which was delivered to the Jackson Hole conference in 2007. As he notes in the opening (emphasis, again, ours):
When you look back over the past half-century in the United States you see a remarkable secular change in the housing cycle. Most importantly, the volatility or average size of the fluctuations in residential construction declined. The change occurred in the early 1980s. For example, compare two periods, the first before the early 1980s and the second since the 1980s. In the earlier period the standard deviation of residential investment relative to trend was around 13 percent; in the later period it was 5 percent, and this includes the most recent fluctuation, which is much larger than the averaqge since the early 1980s. Without the current cycle the reduction would be even larger.
Isn’t it curious that the timeframe Taylor identifies coincides very neatly with the whole timeframe of Greenspan’s tenure at the Fed: 1987-2006.
Anyway, QED:
…this decline in volatility was largely due to an improved monetary policy and it is closely related to the Great Moderation of the volatility of real gross domestic product (GDP) and inflation, which many researchers have attributed to monetary policy. Compared to the earlier period, monetary policy has been much more responsive since the early 1980s to changes in inflation and real GDP.
The really interesting part of Taylor’s paper though – in light of Greenspan’s recent remarks – comes next.
Taylor claims that between 2003 and 2006, the Fed cut rates far more than it should have done, according to existing policy precedents – specifically those based on the Taylor rule, a centrepiece of central bankers’ policy diagnostic tool kits since Taylor himself proposed it in 1993.
In a nutshell, the Taylor rule prescribes an interest rate responsive to changes in actual GDP and inflation from target GDP and inflation.For most of Greenspan’s tenure, the interest rate decisions indicated by Taylor rule – whether deliberately or not – closely mirrored the actual decisions taken by the Fed. Except for the three years during 2003-2006. We’ll let the following two charts do the rest of the talking. The first is of the actual interest-rate chosen by the Fed, versus the “counterfactual”, Taylor-rule based rate. And the second shows housing starts, with the actual data plotted against a simulation of starts had interest rates followed the Taylor rule (labelled as “counterfactual simulation”):
Related links:
Less maestro, more ingénue – FT Alphaville
Housing and monetary policy - John B. Taylor