Thursday, January 18, 2007

Leaning Against the Bubble

January is shaping up to be a pretty interesting month for interpreting Federal Reserve statements as they relate to housing.

It’s clear now that the Fed is very aware of the real possibility that we are about to experience a sharp correction in home prices and they are not only concerned about the spillover effects on consumption and economy as a whole but they are also taking “appropriate” action.

In the past, Federal Reserve Chief Ben Bernanke has argued that he does not support the “lean against the bubble” philosophy that would have the Fed practice and extra measure of monetary tightening on account of a presumed asset bubble.

In a speech given Wednesday, Federal Reserve Governor Fredric S. Mishkin reiterates this argument nearly identically except this time the unnamed and fictitious “asset bubble” of the Bernanke speech has been replaced with the very real “housing bubble”.

Both Bernanke and Mishkin argue that the central bank does not have an “informational advantage” over the free market that would allow it to better identify an asset bubble (i.e. properly price an asset better than the market can) and that, even if it did, monetary policy is far to blunt and instrument to use to control excessive price inflation for a single asset like housing.

Instead, they suggested that the Fed should only set monetary policy based on its fundamental charter of managing general inflation in the economy.

If an unusual asset bubble were to show itself to effect the economy as a whole, so be it, but the Fed is not willing to take what some would call “an extra measure of security” with extra tightening in a reaction to the presumed existence of a single asset bubble such as home prices.

Furthermore, both Bernanke and Mishkin agree that the Fed should take full advantage of its supervisory and regulatory powers in helping the nations financial institutions better cope with risks posed by sudden asset price declines.

In addition, both seem to agree that the Federal Reserve is far more effective at “mopping up” after a financial crisis than preventing one and that the Fed is prepared to fulfill its duties as a lender of last resort should institutions start to reel from sudden losses.

An important point to note here is that the Feds unwillingness to react to a single asset bubble should go both ways thus preventing them from raising rates to stave off an asset price bubble as well as cutting rates to stave off an asset price collapse.

In fact, this was exactly the sentiment noted in a speech by Vice Chairman Kohn last year when he suggested that home owners should not expect the Fed to act to preserve recent home prices gains.

Additionally, with the release of their regulatory guidelines for home mortgage lending, it’s easy to see that the Fed is executing as outlined.

Today though, Mishkin succeeded in putting the real face of the housing bubble on the fictitious “asset bubble” of the Bernanke speech.

Posted by at