Tilting at Bubbles

Source: Wall Street Journal

The Wall Street Journal reports on the "Fed's Unsolved Puzzle: How to Deflate Bubbles" (That's the print version headline, much pithier than online.)

I thought I was reading The Onion. There it is, a graph marked "Asset Bubbles," measured, apparently, with interferometer precision.


I must have been asleep or something, since the last time I touched base with finance, mid-yesterday, we still didn't have an operational definition of "bubble," let alone a way of measuring one, beyond academics and Fed officials looking out their office windows and opining that prices seem awfully high (but not quite enough for them to put on a big short.) Let alone any scientific understanding of what policies might calm such bogeymen. How does the Fed know a "bubble" from a "boom," an "irrational valuation" from a rational willingness to take risk in a slow but steady real economy?

And, much more importantly, when did it become the Fed's job to diagnose and prick its perceptions of asset price "bubbles?"

Yet here we read

Six years after the financial crisis ended, the central bank remained ill-equipped to quell the kind of dangerous asset bubbles that destabilized the savings-and-loan industry during the late 1980s, tech stocks in the 1990s and housing in the mid-2000s.

...financial bubbles have been root causes of the past three recessions

 Iowa farmland prices rose 28% between the fourth quarter of 2010 and the fourth quarter of 2011, igniting fears of a dangerous bubble

Apparently "bubbles" have made their way from Monday-morning quarterbacking to established and measurable facts. (To clarify, this is a news story not an editorial, and the reporters, Jon Hilsenrath and David Harrison, are just passing on what they hear. )

Commercial real-estate prices are soaring and Fed officials face the conundrum of what, if anything, to do.

Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms.

Even though many Fed officials favor using regulatory powers over interest rates to stop bubbles, the U.S. was a “long way” from establishing a regulatory system that could achieve that, Mr. Dudley said in September. 

Your darn tootin' they face that conundrum. Because diagnosing the sources of, and controlling, asset and real estate prices is not, and never has been, part of the Fed's job. 

The Fed has great power and independence. The price of that power and independence is limited sphere of action. It's also wise. Once the Fed becomes the central planner of real estate prices, and allocator of credit to control prices, it will neatly be sandwiched into a political role. Sellers and developers want more, and chant "prices are depressed, stimulate." Buyers want less and chant "pop this bubble" (but give me credit to buy.) The only possible answer is, real estate prices are just not our business.

Central banks have always been severely limited by statute and tradition to what they can try to control, and what tools they can use, in return for their independence. Traditionally, the central bank bought only short-term treasuries, and controlled only short-term interest rates, and its targets were limited to inflation and employment.  Intervening in mortgage backed security and long term treasury markets is already a stretch. Using interest rates to target asset prices is a stretch. Using regulatory power, to allocate credit, to control real estate prices, is way, way beyond the Fed's mandate.

Memo to Fed:  There is already a chorus angry at how much you exceed your sphere now. You may regard them as ill-informed peasants with pitchforks, but they happen to occupy seats in Congress and they're writing bills. If you decide to judge whether the price of farmland in Iowa is a "bubble," and to use your regulatory powers to stifle credit to Iowa farmers with the goal of determining the just price of farmland, those peasants with pitchforks aren't going to take it quietly.

The Fed has neither authority, mandate, road map, nor regulatory measures, because controlling real estate prices is no more its job than controlling carbon emissions. Congress could change that, and give the Fed broad authority. But it has not done so.

To be fair, perhaps this is a natural extension. The Fed took on the job of propping up house, bond, and arguably stock prices in the recession, and there is not a huge outburst of complaint. Perhaps therefore it is entitled to tamp down house, bond, and stock prices in a boom, if it so desires. Oh wait, there is a huge outburst of complaint.

Mr. Rosengren [president of the Boston Fed] had noticed more building cranes in Boston.

“Given our low interest rates, given that it is an interest-sensitive sector, it is probably worthwhile to start thinking about at what point do we become concerned that is growing too rapidly,” he said.

The Fed’s low interest-rate policies have helped drive investors into such assets as commercial real estate as they search for higher returns.

Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms. (Repeated, with emphasis) 

The vague rationale for intervention is that there is a difference between "boom" and "bubble," between asset prices that are high because of "real" valuations vs. "irrational" ones, between something like "supply" and "demand" and somehow the Fed can tell in real time, offset the bad and allow the good. But that all disappeared in the above paragraphs. Boom and bubble are now the same. And we're not even talking about national or "systemic" "bubbles" anymore. Now the Fed is supposed to worry about the price of farmland in Iowa

This is how it's supposed to work. The Fed lowered interest rates, that raises asset values, higher asset values induce people to invest, which is "stimulative." Q theory 101. How do we know it's "too much?"

Despite the action in commercial real estate, debt levels across the broader financial system are still modest. Overall U.S. financial sector debt— $15.2 trillion in the second quarter—was down 16% from the third quarter of 2008. Financial sector debt has fallen to 84% of economic output from 125%, a sign the economy is less prone to a financial crisis on the scale of 2008.

“Our quantitative measures indicate a subdued level of overall vulnerability in the U.S. financial system,” Fed economists said in an August research paper that sought to assess risks of banks and markets overheating.

Now we're getting somewhere. How are asset price gyrations a "risk" anyway? Answer: if and only if they make their way through debt to default and runs. The right answer to such worries is to make sure there isn't a lot of debt in the way, and let asset prices do whatever they want to do. Keep people from storing gas in the basement; don't try to stop them from ever lighting a candle. The project that the Fed will micro manage prices so nobody ever loses money again is hopeless.

And the bottom graph looks pretty darn good. So what is the worry? If there is no debt in the way, why must the Fed try to control prices?

Some of them, including Ms. George [president of the Federal Reserve Bank of Kansas City] said rates weren’t the right instrument to use against bubbles. She favored demanding banks hold more capital.

Excellent! (I presume she was misquoted, as banks issue capital, they don't hold it, but a minor quibble.)

The graph: I looked up the original here, in a nice paper titled "Mapping Heat in the U.S. Financial System." The paper does not pretend to define or measure "bubbles." It's a nice index number/visualization/forecasting exercise with many more pretty graphs.