Arnold Kling  

James Hamilton at a Fed Conference

A Question for Bryan... An Answer For Arnold...

At Econbrowser, James Hamilton has many interesting posts from the annual Fed conference at Jackson Hole, where the housing kerfluffle drew a lot of attention. In one post, he writes,

But if it were the case that all these institutional changes are just a response to interest rates, it means that the lags in the monetary transmission process are substantially longer than many of us had supposed. If people were still buying houses in 2006 as a result of institutions that sprung up from the conditions in 2004,it means that, if we thought in 2004 that overstimulation could easily be corrected by bringing rates back up, then we would have been wrong. And likewise, suppose you believe that the pain we're seeing now, and may continue to see for a matter of years, until the new loan originators all go out of business, and recent buyers are forced out of their homes, is simply a response to a monetary tightening that ended a year ago. If so, then if we think today that, if things get really bad, we can always fix things by rapidly bringing interest rates back down-- well, then, once again, we'd be wrong.

He is trying to compare two types of explanations for the problem in subprime mortgages. One explanation is that the system for managing risk broke down, and investors made decisions that in retrospect were clearly stupid. In that case, perhaps some regulation is in order. (My view would be that such regulation would be classic post-horse barn-door closing, with little or no constructive effect.)

Another explanation is that the monetary environment somehow inevitably caused people to lose track of risk. This is a seductive story, in that clearly some people misjudged risk badly, and in a different (tighter) monetary environment they would probably have been brought to their senses sooner. But I think that one should resist the seduction of that story.

The goal of monetary policy should be to maintain an environment of low inflation. In an environment of low inflation, if investors set risk premiums low, then there will be a boom. That boom may be followed by a slump. I do not think that the Fed should try to fine tune its way through those sorts of cycles. By trying to stick to an inflation target, the Fed is doing enough to lean against the wind.

I see movements in risk premiums as not particularly predictable. The timing and magnitude of the effect of these movements on macroeconomic performance is another source of uncertainty. The economy itself seems to be much less volatile than financial markets. For the Fed to start to key off financial markets in making policy seems to me like a recipe for greater instability, not less.

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CATEGORIES: Macroeconomics

COMMENTS (3 to date)
David Thomson writes:

Does political correctness have anything to do with it? Tremendous pressure was placed on lending institutions to provide mortages to minorities. Did some of them look the other way because they were intimidated to do so?

spencer writes:

You wrote:
such regulation would be classic post-horse barn-door closing, with little or no constructive effect.

You talked about this in an earlier post and I did not respond, but I have problems with this line of thought.

In a dynamic economy private individuals are always developing new methods and innovations.
This is a great benefit. But as almost always happens in financial markets some people take the new innovations to its illogical extremes and this creates problems.
In you earlier post you talked about regulation preventing this from happening.
But that is not a desirable outcome because the regulators could not know before hand what is too extreme or where to draw the line.

We should allow these extremes to happen so we get the benefits of innovation. The damage is a reasonable cost of innovation. but at this point
regulations should be created to establish the new limits and prevent the extremes and their cost from being imposed the next time around. Such cost on a one time basis are a reasonable cost for innovation, but allowing it to happen time and time again is an unnecessary cost.

Matt writes:

I can tell you one error in inflation measure, the cost of mortgage interest.

Inflation should strictly be the rent for goods and services for the hypothetical consumer that owns no capital equipment. This is the value of an infinite term bond, cash.

Mortgage costs occupy the 1/30 year point in the (frequency based) yield curve, and if the CPI puts weight on mortgage payments and adds that to the infinite term bond, then it will have a tendency to flatten out the top of the yield curve, this is unstable.

The other problem is the semi-monopoly status of the fed. It cannot help but stretch the inflation expectations game to the max so its members have available a differential interest rate advantage. The solution here is to get every citizen logged into the discount window so we all see inflation dollars attributed to our accout at the same interest rate member banks get. This solution creates a direct, immediate path between a change of interest rates and inflation expectations.

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