Donald L Kohn: Monetary policy and asset prices revisited
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Cato Institute's Twenty-Sixth Annual Monetary Policy Conference,
Washington DC, 19 November 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
As you know, we are in the midst of a global financial crisis that is now weighing heavily on
economies around the world. Although the outlook remains extremely uncertain, both the
fragility of the financial system and the weakness in real activity seem likely to persist for a
while. To promote maximum sustainable economic growth and price stability, the Federal
Reserve has responded to this crisis by easing monetary policy markedly, and we have
greatly expanded our liquidity facilities to keep credit flowing when private lenders have
become reluctant or unable to do so. Other central banks have also cut policy rates
significantly and expanded their lending. In addition, the federal government and
governments around the world have taken extraordinary actions to strengthen financial
systems to preserve the ability of households and businesses to borrow and spend.1
The current situation is so severe that it calls for careful review of how such a crisis evolved
and how we can prevent a similar situation from happening again. This conference is a
welcome step in that review, as it asks about the lessons we have learned, particularly for
monetary policy, from the collapse of subprime lending and the preceding house-price
bubble - developments that contributed importantly to the present financial crisis.
This morning I would like to reflect on some of what I, in my role as a monetary policymaker,
have learned from recent developments in the housing sector and, more broadly, in financial
markets as a whole. In doing so, I will revisit the remarks I made in 2006 in Frankfurt at a
festschrift for Otmar Issing.2 There I argued that a central bank facing a possible asset
bubble would have to surmount some high hurdles before it would be justified in tightening
policy beyond what the outlook for output and inflation would require, after taking into
account past and projected asset price developments. In the aftermath of the collapse of the
housing market and in the midst of the ensuing financial and economic turmoil, does that
conclusion still hold? More time and study will be needed before we can be confident about
the lessons of the current crisis. But to foreshadow the remainder of these remarks, based
on what we know today, I still have serious questions about whether trying to use monetary
policy to check speculative activity on a regular, systematic basis would yield benefits that
outweigh its costs.
I hasten to add that it is evident from the current crisis that much has to change on the
regulatory front. Governments around the world face the challenge of revamping the
regulatory structure governing financial markets. And changes in this area, I believe, will
prove to be the most necessary and effective at reducing the odds on another severe
financial crisis. Today, however, I will focus on some of the lessons of the current crisis for
monetary policy per se.
Alternative strategies for addressing asset price bubbles
In my 2006 speech, I discussed two different strategies for monetary policy to deal with a
possible asset price bubble - the "conventional strategy" and "extra action." A central bank
following the conventional strategy does not attempt to use monetary policy to influence the
speculative component of asset prices, on the assumption that it has little ability to do so and
that any attempt will only result in sub-optimal economic performance in the medium run.
Instead, the central bank responds to asset price movements, whether driven by
fundamentals or not, only to the degree that those movements have implications for future
output and inflation. This conventional strategy conforms to the Federal Reserve's dual
mandate under the law and it has been our policy strategy; it also has been consistent with
the practices of most inflation-targeting central banks.
However, some observers have argued for a more activist policy than this one. Specifically,
they have urged central banks, upon perceiving the development of an asset bubble, to take
extra action by tightening policy beyond what the conventional strategy would suggest, with
the hope of limiting the size of the bubble and thus the fallout from its deflation. Such a
strategy, if successful, could deliver substantial benefits, and a number of central bankers
have talked about the need to consider a policy of extra action on occasion, and perhaps
have even implemented such a strategy. However, taking extra action also would entail
some costs, such as creating, for a time, higher unemployment and lower inflation than
would otherwise be desired.
In assessing these two alternatives for monetary policy, in the 2006 speech I concluded that
a strategy of extra action might be justified if three tough conditions were met. First,
policymakers must be able to identify bubbles in a timely fashion with reasonable confidence.
Second, a somewhat tighter monetary policy must have a high probability that it will help to
check at least some of the speculative activity. And third, the expected improvement in future
economic performance that would result from the curtailment of the bubble must be
sufficiently great. Of course, we live in an uncertain world, and accordingly policymakers
should always be open to the possibility that these conditions might be satisfied and that
extra action would be appropriate. But my thought at the time was that, in practice, the
likelihood of ever meeting the three conditions seemed remote. In the aftermath of the
bursting of the housing bubble, however, the severity of the fallout might seem to call this
judgment into question. So let's re-examine each of the three conditions and see what the
current crisis has taught us.
Potential gain from limiting bubbles
Let me start with my third condition, the potential gain from limiting bubbles, because this is
where my views have changed the most. Although I was concerned about the potential
fallout from a collapse of the housing market, I think it is fair to say that these costs have
turned out to be much greater than I and many other observers imagined. In particular, I and
other observers underestimated the potential for house prices to decline substantially, the
degree to which such a decline would create difficulties for homeowners, and, most
important, the vulnerability of the broader financial system to these events.
In retrospect, I may have been unduly comforted by the resilience of the U.S. economy to the
collapse of the high-tech bubble, to the earlier Russian debt default and failure of Long-Term
Capital Management, and even to the commercial and residential real estate debacles of the
late 1980s and early 1990s (as difficult as that recovery was). But mopping up after this asset
price bubble has turned out to be much harder because of its greater magnitude, the
centrality of residential housing and finance to our economy and financial system, and the
surprising ways obscure and complex financial transactions have exposed banks and other
financial institutions to heavy losses. In addition, financial and economic linkages across
countries have made this crisis truly global in scope, affecting both developed and
developing economies. As a result of all these factors, the economic disruption here and
abroad is likely to be considerably more severe than in past episodes.
The severe fallout may indicate a larger potential gain than I had anticipated to leaning
against excess exuberance in asset markets. However, realizing that potential rests on
meeting my two other conditions as well - the timely identification of the bubble, and the
ability of a central bank to materially influence the trajectory of the speculative component of
asset prices.
Identifying bubbles in a timely manner
As for the first of the three conditions, events of the past few years, coupled with advances in
our understanding of how bubbles form and persist, have made me a little less dubious that
policymakers can reliably identify a serious bubble before it bursts. However, I am still
skeptical about our ability to detect bubbles early enough to make a general policy of leaning
against them successful on average.
The identification of bubbles in real time is tricky because not all the fundamental factors
driving asset prices are directly observable; thus, any judgment by a central bank that an
asset is overpriced is by nature uncertain. My views on this aspect of the identification
problem have been reinforced by my experience during the inflation of the housing bubble.
Over the first half of the decade, we saw a sustained, rapid rise in both home values and
mortgage debt. As this process continued, concern about its sustainability grew and many
observers started speculating that a bubble was in place. During this period, staff throughout
the Federal Reserve System examined whether house prices were overvalued and arrived at
a wide range of answers. For example, one set of models that linked rental rates and house
prices indicated as early as the start of 2004 that the market was significantly overvalued,
while another set of models suggested, even as late as December 2005, that house prices
could be justified by fundamentals.3 Thus, controversy over the existence of bubble persisted
almost right up to the actual peak in the housing market.
Because the economic consequences of mistakenly responding to a misidentified bubble are
substantial, central bankers may be reluctant to take extra action in the face of such
uncertainty, especially if they are risk-averse. Policymakers may also be reluctant to act
because a bubble "call" might seem to require them to be more knowledgeable than market
participants. After all, if at least some market participants perceive the emergence of a
bubble, wouldn't they arbitrage that mispricing away? Recent research, however, suggests
reasons for why market participants who think they know that a bubble exists still may not
trade to eliminate it. For example, if some market participants recognize the presence of a
bubble but do not know how common their knowledge is, they might reasonably expect to
make the most profits by riding the bubble for as long as possible, with the goal of trying to
sell the asset just before it collapses.4 Other research emphasizes that certain institutional
structures - such as secured lending and delegated portfolio management - can create
substantial costs in trading against an asset price bubble, so that even market participants
who are conscious of the bubble will not find it profitable to trade against it.5 Together, these
studies suggest that policymakers may be able to detect bubbles that will not be quickly
arbitraged away, thus strengthening the argument for considering extra action.6
Nonetheless, even if policymakers are confident that a bubble has emerged, the question of
the timeliness of the call remains. The essential problem is the timing of the detection of the
bubble relative to the timing of its collapse. The risk is that the detection and subsequent
policy response occurs not long before the bubble collapses on its own. Given the lags
associated with monetary policy, the resulting contractionary effects on the economy of the
monetary tightening would occur just when the adverse effects of the bubble's collapse are
being realized, worsening rather than mitigating the effects of the bubble's collapse. And the
inevitable lags in detecting bubbles increases the likelihood that, by the time action is taken,
speculative activity will have progressed to the point that its collapse is not far off. Thus, even
if we could have known for sure that a housing bubble existed, and that tighter monetary
policy would have significantly checked the unwarranted rise in home prices, policymakers
would have had to make this call early on - at least a year and probably more before the
peak in the real estate market in 2006 - for such an action to have been beneficial.
Ability of monetary policy to influence bubbles
This brings me to the remaining condition - the requirement that monetary policy be able to
materially check expansions in asset bubbles. Clearly, interest rates play an important role in
determining the fundamental value of corporate equity, houses, and other assets. However, I
noted in my earlier speech that the influence of interest rates on the speculative component
of asset prices is unclear from both a theoretical and empirical standpoint.
My views on this issue have not changed much, largely because of the still-murky role that
monetary policy played in promoting the surge in house prices and the accompanying run-up
in both conventional and subprime mortgage debt. Although tighter monetary policy might
have succeeded in shifting down the path of house prices, it is still not clear to what extent
small or even moderate policy actions would have discouraged the broader speculative
developments that have characterized the current episode: overly-optimistic expectations of
price appreciation, excessive leveraging, and a marked increase in risk-taking by
homeowners and investors. Of course, a substantial tightening of policy, leading to a
significant slowing in the economy and rise in unemployment, might have had a marked
effect on housing price gains. But undertaking such a policy course on a regular basis
whenever asset price misalignments are detected would likely prove to be a relatively poor
strategy on average, especially given the possibility of false positives in identifying these
misalignments, and the existence of other potential remedies. In general, taking
moretargeted steps - for example, regulatory changes intended to strengthen the financial system
- would seem a better course of action under such circumstances.
To be sure, some observers contend that the low level of the federal funds rate in 2003 and
2004 was clearly a primary cause of the housing bubble, and that a significantly tighter
stance of monetary policy would have been warranted. As you know, the Federal Open
Market Committee (FOMC), after having sharply lowered its policy rate during the 2001
recession, further lowered the federal funds rate in late 2002 and 2003 in response to an
outlook for continued tepid real growth and a possible unwelcome disinflation. This
accommodative stance helped set the stage for a more robust recovery, and as the
expansion took hold in 2004, the FOMC began to tighten in a gradual manner that was
publicly signaled in advance.
How might these monetary policy actions have fueled speculation? Perhaps a low policy rate
early in the decade, by stimulating housing demand and pushing up the level of home prices,
incorrectly led households and lenders to extrapolate these price increases into the indefinite
future. Overly optimistic expectations may have had an unusually stimulative effect on the
housing market after 2003 because borrowing constraints were being eased by new financial
developments, such as the growth of subprime lending and other nontraditional mortgages,
fueled in part by investor demands for the higher yields on complex structured products.7 In
addition, the increased use of adjustable-rate mortgages - which are more closely tied to
short-term policy rates - may have initially boosted the stimulus from a lower federal funds
rate.
These stories have a certain plausibility, but a closer examination raises questions about
monetary policy and the housing and credit bubbles. Although low short-term interest rates
probably supported housing demand and home prices for a time - an effect that helped to
offset the negative effects on economic growth and employment of the steep decline in
business investment - the role of monetary policy in fueling the speculation in real estate is
still not clear. Studies that have tried to address how much monetary policy contributed to the
increase in house prices during this period are inconclusive.8 And in general, the channel
from interest rates to house prices has not been strongly established empirically, suggesting
it might take a very large hike in the federal funds rate to have a substantial effect on real
estate values.9 Moreover, if accommodative monetary policy engendered extrapolative
expectations and speculation starting in 2003, why did it not restrain these factors after
mid2004 as the federal funds rate was increased? Tightening should have limited the extent to
which households (especially those using variable-rate mortgages) were able to borrow,
thereby slowing the pace of house price appreciation. Furthermore, many of the worst
subprime loans were made after the federal funds rate had normalized, and reflected a wide
array of deficiencies in the financial markets.
The contrasting movement of short-run and long-term interest rates over this period further
complicates any assessment of the link between monetary policy and the housing market.
Housing demand and home prices are, presumably, most closely linked to the 30-year fixed
mortgage rate and the expected average borrowing rate to be paid over the life of
adjustablerate mortgages. That these actual and expected loan rates moved sideways even as the
federal funds rate rose suggests that other factors beside monetary policy were at work,
especially since the FOMC clearly signaled that it would be returning the funds rate to a
normal level over time (albeit at a "measured pace").
A good portion of the appreciation in house prices probably owes to the structural changes
that were taking place in mortgage financing - specifically, the opening up of subprime
lending and the expansion in associated securitization markets with its strong demand for
mortgages from investors. Gauging the effects of expanded subprime lending on house
prices is complicated by two-way causality - more lending can drive up house prices but
expected house price increases can also induce more lending. Undoubtedly, causality did
indeed run both directions. But studies do indicate that an expansion in credit leads to
increased house prices, and suggest that structural changes in mortgage finance likely
boosted the rate of house price appreciation.10
Another key observation that must be reconciled with any explanation of recent events is that
the run-up and subsequent decline in house prices was not limited to the United States;
indeed, some countries have experienced even larger swings in house prices.11 In most
countries during this period, long-term interest rates were low despite the fact that their
central banks did not ease as markedly as the Federal Reserve. A common factor behind
these low rates, and perhaps in part behind the shared increase in house prices as well, is
the "global saving glut" identified by Chairman Bernanke - the large amounts of savings,
both official and private, from Asian and oil-exporting nations that tended to lower neutral
interest rates globally.12
In a broader sense, perhaps the underlying cause of the current crisis was complacency.
With the onset of the "Great Moderation" back in the mid-1980s, households and firms in the
United States and elsewhere have enjoyed a long period of reduced output volatility and low
and stable inflation. These calm conditions may have led many private agents to become
less prudent and to underestimate the risks associated with their actions. While we cannot be
sure about the ultimate sources of the moderation, many observers believe better monetary
policy here and abroad was one factor; if so, central banks may have accidentally contributed
to the current crisis. But would a somewhat tighter stance of policy in recent years have
reversed this complacency? It seems doubtful. Central banks would likely have needed to
produce recessions of some consequence in order to force agents to reevaluate the costs of
taking on risk - an outcome unlikely to improve societal welfare. Rather than using the blunt
tool of monetary policy to induce prudence, we should examine more closely the possibility of
using regulation and prudential supervision to address concerns about overleveraging and
other risk-taking behavior.
In short, we still do not fully know what caused the run-up in house prices and over-building.
Short-term rates were low in 2002-04 as the Federal Reserve countered the risks it saw to
good economic performance, and these low rates probably had some effect on housing
markets at the time. But the problems largely built up after policy rates were well on their way
to neutral, and other factors appear to have played major roles. We have learned little about
the likely effect that a somewhat higher funds rate would have had on the speculative
element of prices. Of course, it is important to keep an open mind about the relationship of
short-term interest rates and speculative activity. If it becomes clear that monetary policy can
predictably influence the evolution of bubbles, central banks should take that ability into
10
Mian and Sufi (2008) found that Zip code areas with high latent credit demand prior to the bubble's emergence
experienced larger expansions in the supply of mortgage credit and larger increases in house prices, despite
being subject to weaker economic conditions; this result also held for Zip codes that, because of inelastic
housing supply, would not be expected to see price increases above the inflation rate for construction costs.
Overall, this study attributed 40 percent of the national rise in house prices to increased subprime lending.
Leamer (2007) noted that house price increases occurred in some of the lowest priced Zip codes. Wheaton
and Nechayev (2008), using results obtained from time series regressions for a number of different housing
markets over the period from 1975 to 1998, found that a correlation between measures of credit availability
and unexplained movements in house prices, which suggests that structural changes in mortgage finance may
have contributed to the increase in house prices. Finally, the International Monetary Fund (2008) found
evidence that countries with the most advanced housing finance systems are more exposed to housing sector
shocks.
11
In addition, housing credit in several other countries appears to have expanded beyond the traditional pool of
households in recent years, although probably (comparable data are scarce) to a lesser degree than in the
United States.
12
See Bernanke (2005).
BIS Review 144/2008
account when crafting policies intended to keep output rising in line with its potential and
inflation low and stable.
Summing up
In sum, I am not convinced that the events of the past few years and the current crisis
demonstrate that central banks should switch to trying to check speculative activity through
tighter monetary policy whenever they perceive a bubble forming. The recent experience
may have made us a bit more confident about detecting bubbles, but it has not resolved the
problem of doing so in a timely manner. Nor has it shown that small-to-modest policy actions
will reliably and materially damp speculation. For these reasons, the case for extra action still
remains questionable, despite our having learned that the aftermath of a bubble can be far
more painful than we imagined.
Some may object to this assessment, arguing that the current crisis is so bad that, in
retrospect, monetary policy should have been appreciably tighter to deflate or forestall the
housing boom earlier in the decade, even if that meant a substantially weaker economy. This
argument has two defects. First, monetary policy is made in real time, not with the benefit of
hindsight, and any evaluation of competing strategies for the systematic conduct of policy
must be grounded in that fact. Although we must learn from history, we cannot implement
policy strategies that assume more information about the future than we can ever have.
Second, even if we ignore the fact that policymakers at the time could not have known what
the future held in store if the funds rate followed the path it actually did, we also need to
recognize that we cannot be sure what would have happened if policy had taken a different
course. If policy had tightened appreciably at an early stage of the housing boom, say in
mid2003, it would have done so when the unemployment rate was still rising and inflation
seemed poised to move to an undesirably low level. Such a course of action might well have
created its own unforeseen consequences that we might now be ruing.
This assessment aside, recent events would seem to have some implications for the conduct
of monetary policy. For example, in light of the demonstrated importance to the real economy
of speculative booms and busts (which can take years to play out), central banks probably
should always try to look out over a long horizon when evaluating the economic outlook and
deliberating about the appropriate accompanying path of the policy rate. The Federal
Reserve staff has for sometime regularly provided the FOMC with this sort of
extendedhorizon analysis. In particular, the staff regularly generates likely paths for the economy over
the next five years or so under different economic and policy assumptions; these scenarios
often highlight different possibilities for the evolution of prices for homes and other assets.
Note that the focus here is not a single baseline outlook; rather, the emphasis is on exploring
the various ways events could play out and the implications for monetary policy.
Another lesson of the current crisis is that central banks need to improve their understanding
of the workings of the financial system, its vulnerabilities, and its links to the real economy.
We must try to find ways to discern more quickly if financial innovation and other factors are
leading to a buildup of destabilizing forces, such as rapidly rising asset prices or excessive
leverage. Moreover, the unexpectedly rapid resonance of financial turmoil through global
markets signals a need for further study of the complex cross-country linkages among
lenders and borrowers, and the ways in which those linkages are influenced by such factors
as leverage, interdependent counterparty relationships, and backup liquidity agreements.
Finally, more effort needs to be spent on further investigation of the financial accelerator and
other credit-channel effects, given the accumulating evidence that such effects can give rise
to an adverse feedback loop between financial markets and the real economy. Overcoming
these deficiencies in our knowledge will not be easy, but the potential benefits could be
great.
Finally, as I emphasized at the outset, we must thoroughly review the regulatory structure of
the U.S. and global financial systems, with the objective of both identifying and implementing
the comprehensive changes needed to reduce the odds of future bubbles arising, and
improving the ability of banks and other financial institutions to weather the fallout from
unexpected adverse changes in asset prices. Ultimately, this process should prove our best
line of defense against the problems of the sort we now face.
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