« Politically Incorrect Paper, a continuing series | Main | The best sentence I read Friday morning »
Don't get so worked up about the Fed
We have seen here that the big movements in stock prices and real estate prices in the last decade or so do not line up with movements in long-term interest rates over the same time period. This appears to confirm the 1988 results of Campbell and Shiller that stock prices relative to dividends or earnings are not well explainable in terms of present value models with time-varying interest rates.
That is Robert Schiller, in a new paper, via New Economist. And while I do think the Fed can influence real interest rates -- especially short rates -- this ability should not be taken for granted either. So if you want to blame the subprime crisis on loose monetary policy from the years of the dot.com bubble burst, you have some explaining to do.
Posted by Tyler Cowen on September 15, 2007 at 12:33 PM in Economics | Permalink
Comments
I personally prefer mass stupidity / myopic decision-making as an explanation. Unfortunately, that is somewhat difficult to incorporate into a model...
Posted by: Alex at Sep 15, 2007 1:10:16 PM
The value of a stock (or a company) is determined by supply and demand. People use different models to determine what they think the stock is worth. These can be technical models (above 200 day MA = buy), fundamental models (DCF), or some combination of the two (factor models?). People will buy stock for many different reasons. I agree with Shiller that models are not perfect and people are not perfectly rational the way that EMH predicts. However, just showing graphs of what long term rates are and how broad aggregates performed says nothing about what market participants expectations were or what models seem to have lead to the pricing that occurred.
Here's an interesting thing to check. Download the monthly historical pricing information for QQQQ back to 95 and VGSIX (Vanguard's REIT fund) as far back as it goes. Divide the monthly price by the market's top for each series and graph them on one graph with date on the x axis. To me, this is a much better indicator of what has happened in the past 10 years or so. You'll see very clear market tops in this graph. Personally, I think the bulk of money is controlled by market participants who far too short-sighted. Interest rates may be low historically, but if you compare ^IRX from today to four years ago, interest rates look very high. It is very hard to reconcile the fact that short-term interest rates dropped so low and then all of sudden there was a very large boom in housing (b/c of expectations of cash flows in the future, stocks didn't immediately go up). The money pumped into the system had to have gone somewhere. Also, in October of 98 short-term rates were at 4.2 and by August of 2000 they were at 6. It isn't a coincidence that higher interest rates choked off investment in tech and helped cause that crash. Using real interest rates just doesn't show the same story as the short-term rates do.
To conclude, interest rates aren't the sole driver of stock prices, but the Fed's manipulation of interest rates has obviously caused the past two asset bubbles. (Someone told me the other day that he thought the recent subprime problems was partly because of the macro issues and partly because investment bankers were getting greedy. IBankers have always been greedy, what has changed?)
Posted by: John at Sep 15, 2007 3:35:17 PM
We have seen here that the big movements in stock prices and real estate prices in the last decade or so do not line up with movements in long-term interest rates over the same time period.
Yep, I agree, they line up better with Tax cuts given to the economy.
So if you want to blame the subprime crisis on loose monetary policy
How about a misguided Fed Monetary policy of using interest rates to stifle the demand for money.
Oh, and I dont believe on bubbles.
Posted by: russ at Sep 15, 2007 4:57:34 PM
I blame China's appetite for bonds for keeping interest rates low. Remember when the Fed started raising short rates, and long rates mysteriously refused to follow along?
Posted by: Mitch at Sep 15, 2007 6:29:13 PM
I don't get it...
The Federal Funds Rate was dropped to 1% for a year or so, and was generally kept very low in other years. We know that newly-created money is going to be loaned out in one fashion or another, because the decision to lend is effectively a prisoner's dilemma for bank. I can understand how low rates in the long-term could make this worse, but it seems like short-term low rates could also cause a problem. After all, the housing and dot-com booms were not long-term phenomenon, so I wonder how relevant long-term interest rates are.
But, were there somehow more wise investments to be made just because the the Fed decided to drastically lower interest rates? How would that be possible? And if there weren't any more good investments, then how could the credit expansion possibly go into wise investments?
Alex, some people were certainly stupid. But most I know who were involved in either the housing or dot-com bubble were simply riding the boom, hoping to get in and get out before it burst. Thats certainly not a scientific observation, of course ;) Still, if its truly mass stupidity, then what could be done about it? A democratic government can be no help in a true case of hysteria, for obvious reasons, though I suppose we don't have a purely democratic government anyways. But I seriously doubt that most investors were actually unaware of the bubble, and the danger.
Posted by: G at Sep 16, 2007 2:35:50 AM
What, pray tell, does Shiller believe is the effect of massive increases in M? Is it unreasonable to conclude that Fed policies during the Greenspan era and today have proven that it is possible to have low levels of inflation (as defined by the government) and still have a bubble-plagued economy? Most economists, with the exception of Card and Kruger, know that when the data contradicts sound theory, there is probably something wrong with the data. Look at Shiller's Figure 8 (p. 25) to see the type of data he is using to base his conjecture which is (tellingly) never tested statistically this paper). Or look at page 8 for the argument that it is simply Milton Friedman's prominence that created the public perception that monetary policy can affect interest rates.
All this raises questions, such as ... Will Tyler vet papers by Shiller for rigor before posting them to MR in the future? Is this what they're teaching at Yale? Are papers like tyhis why Econ Journal Watch was started? Does Shiller think there can be no adverse side effects to policies like this?
Posted by: john at Sep 16, 2007 2:37:31 AM
So if you want to blame the subprime crisis on loose monetary policy from the years of the dot.com bubble burst, you have some explaining to do.
Until you said this, I didn't even realize I was reading something that contradicted my beliefs. Yipe.
Posted by: Noumenon at Sep 16, 2007 7:46:06 AM
For a different opinion, try "Money and the Stock Market: What is the Relation" by Frank Shostak at http://www.mises.org/story/2296. Frank shows that while the interest rate and stocks may not correlate well, the money supply and the stock market do.
Posted by: Fundamentalist at Sep 16, 2007 9:58:49 AM
"So if you want to blame the subprime crisis on loose monetary policy from the years of the dot.com bubble burst, you have some explaining to do."
I don't understand why Tyler brought the Fed into this discussion. The authors of the article don't even mention the Fed as far as I could tell, though I read quickly. Their proposition is that the conventional view that the stock market moves in the opposite direction of long term interest rates is suspect, and they make a good point. The Fed has the greatest influence over short term rates, not long term rates. What determines long-term interest rates? Short-term rates, expected inflation, ROI on competing assets, supply/demand and other things.
I suspect that concern over inflation dominates because it has the greatest potential to cause harm to bond investors. During the 1990's, inflation as reported by official indexes was low by historical standards. So long-term interest rates could remain low. Nevertheless, the money supply grew rapidly during the 1990's. How did we achieve low inflation with a rapid growth in the money supply? Rapid productivity growth. Still, the extra money had to go somewhere and in the late 1990's it went into the stock market, then into commodities and real estate. It now appears to be going back to the stock market.
The excess money supply goes into assets, generally, but not always into long-term bonds, which would affect interest rates. It seems to me that if Tyler really wants to test his theory that the Fed isn't responsible for high asset prices, he needs to look beyond this paper. He would need an index of the major asset categories, stocks, bonds, real estate and commodities, and compare that index with the money supply, not long term interest rates.
Posted by: Fundamentalist at Sep 16, 2007 10:36:56 AM
"So if you want to blame the subprime crisis on loose monetary policy from the years of the dot.com bubble burst, you have some explaining to do."
I've plotted monthly effective rates of Fed Funds versus ARM (national average statistics)from 1986 to 2006 (http://willfulblindness.net/?p=101). In 2004, the ARM rate was at its lowest level for the entire time period covered. Given that lower interest rates result in a greater demand for loans, and that people turned to real estate as a relatively "safe" investment vehicle versus stocks after the dotcom bust (itself most likely a product of low rates set by the Fed), I think it is quite reasonable to believe that the Fed played a major role in the housing boom / bust.
Moreover, prices may take some time to ramp up but once they get going, everyone wants a part of the action. This explains why Shiller sees a time lag between interest rates and housing prices. However, this does not mitigate the position that relatively low interest rates primed the pump.
One open question I have is whether or not lower interest rates would cause banks to take on excessive risk by lending to home buyers with poor credit.
Posted by: Justin Rietz at Sep 16, 2007 11:17:21 PM
hi,I University majoring in the legal profession.After graduation,I 徵信 the work of the strong interest.Has worked in several徵信社.Has a wealth of experience. Now I immigrants France,Hope to continue to engage in the work of徵信 credit.
now,is to wake up every day to drink 咖啡, shopping. I hope that early awareness of Boles.
thanks,thank very much.
Posted by: Bob at Mar 13, 2008 10:28:22 PM
