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Inverting Cause And Effect: Do Asset Prices (And Stock Market Bubbles) DetermineThe Economy And Monetary Policy?

Courtesy of Tyler Durden

Earlier Alan Greenspan shared some Fed insight, explaining the diagonal rise of the stock market, which can be summarized as follows – “stock prices determine the economy, not the other way round.” In one simple sentence, Greenspan demonstrates that the Fed is not only chock full of people who can’t read economic textbooks good (sic) but is populated by a subset of people suffering from cause-and-effect inversion disorder (it is also chock(er) full of new and improved stock traders and algos populating Liberty 33, doing all they can to make sure that in 13 up days, there is just one down). Yet in a market which has broken all laws of rationality, is the Fed’s flawed self-fulfilling prophecy gaming the only thing that the amazing American’s recovery is based on? To be sure, the main reason why economic skeptics such as Rosenberg, Edwards, Janjuah, and (ever decreasing) others retain their pessimism is that while the marker has now priced in one of the most ebullient, V-shaped economic recoveries in the history of the world, the underlying economy has stagnated and even downshifted into a double dip along numerous metrics, even despite ongoing fiscal stimulus and monetary pumpatude. So what is going on? Simple – the Fed, and by implication the administration, believe that once confidence and the market reach a given level, Joe Consumer will forget that the mortgage bill has not been paid in 12 months, the credit card in 3, that all neighbors lost their jobs a year ago and still can’t find a new ones, and instead will merely look at the Dow (not the S&P – for some reason government/Fed workers still don’t realize that nobody follows the DJIA, but whatever) and the UMich consumer confidence, for a barometer of economic health. The fallacy of this proposition is of course beyond preposterous, but these and such are the thoughts of the Federal Reserve.

What the Fed’s fatally flawed policy does create, are asset bubbles of historic proportions, which lead to ever-accelerating boom and bust periods, whose amplitude get bigger and bigger. Yet so far the only person who seems to realize this at the Fed is Kansas Fed President Tom Hoenig. Alas, he is a lone voice as even he acknowledges. 

Appropriately, Goldman’s Sven Jari Stehn has just published an analysis looking at whether there is a two-way relationship between asset prices and the economy (merely the latest in a long line of such queries), and most relevantly: monetary policy. Goldman has long been is a big proponent of ZIRP, claiming that the Fed will not raise the Fed funds rate until the end of 2011 (and possible longer – recently Janet Yellen implied the Fund rate may be at zero until 2013!). Goldman’s findings into the “Greenspan Doctrine” indicate that even something as ridiculous as an S&P level of 2,000 by the end of 2011 will likely not force the Fed into acknowledging there is a bubble. This is shocking, as it indicates that while the Fed inflates the upcoming bubble (which in theory truly could go 25% higher than the last all time high in the S&P), the subsequent collapse will certainly be the last for America. The clock on the final wealth transfer from the middle class to the kleptofascists has begun.

From Goldman:

Do Asset Prices Help Forecast the Economy?

We start by exploring the predictive power of asset prices? such as equity prices, house prices and the spread of the corporate BAA yield over 10-year Treasuries ?for four-quarter-ahead core PCE inflation and the unemployment gap since 1987. A simple way to summarize the predictive content of asset prices is to explore by how much their inclusion reduces the average forecasting error (Exhibit 3).1

Our results confirm earlier studies in suggesting that asset prices contain some predictive power for both future inflation and unemployment but are more informative for the latter.2 For example, we find that the growth of the S&P index helps improve the average four-quarter-ahead forecast of inflation and unemployment by 4% and 5%, respectively. Most strikingly, however, incorporating house prices reduces the error made in projecting the unemployment gap by an impressive 19%. (This result, however, is sensitive to our choice of the sample period which saw a large boom in the housing market as well as falling unemployment.)

How Has the Fed Responded to Asset Prices?

We now turn to exploring whether the Fed has followed the Greenspan doctrine in practice. We find that they have, establishing this in two steps:

First, Fed officials have reacted to asset prices. We find that equity prices and the BAA/UST spread enter the standard Taylor rule significantly (see Exhibit 4). That is, the Fed has responded to movements in those asset price measures in addition to responding to current values of inflation and unemployment. (Similar results obtained when the output gap is used.)  For example, the Fed has increased the federal funds rate by 3 basis points for every 1 percentage point rise in the year-on-year growth rate of the S&P 500. However, although our above results showed that house prices had predictive power during this period, the Fed apparently did not take this information into account (i.e. the coefficient is insignificant).

But, second, the Fed has reacted to asset prices only in as far as they help predict future inflation and unemployment. Strikingly, we find that none of the asset price measures is significant in the ?forward looking Taylor rule.? This result suggests that the Fed has not responded to asset prices in addition to their projections of inflation and unemployment.

These results are consistent with the view that the Fed has followed the Greenspan doctrine in practice and responded to asset price movements only to the extent that they help forecast inflation and unemployment.3

Implications of an Equity Market Boom

Having established that the Fed has followed the Greenspan doctrine in practice, we now examine the implications of a presumed asset price boom for the warranted fed funds rate. As an example to explore the general issue of how to deal with asset bubbles, we focus on equity prices. Specifically, we assume that the S&P 500 will rise at a quarterly rate of 10% (not annualized) for the remainder of 2010 and then half as fast in 2011. Exhibit 5 shows that this is a very aggressive equity market outlook?putting the S&P at 2000 by the end of 2011, a very large increase from our Portfolio Strategy group?s 2010 forecast of 1250.

To put our zero funds rate view to a relatively stiff test, we base our simulations on the Fed?s economic forecasts. We proceed in two steps.

1. The Fed sticks to the Greenspan Doctrine

Assuming that the Fed responds to the hypothetical equity price boom the same way it has done in the past, Exhibit 6 shows that the warranted funds rate rises to -1.6% by end-2011?roughly 90 basis points higher than without paying attention to the equity price boom. (Under our own assumptions, the warranted funds rises merely to -5.9% at end-2011). Therefore, if the Fed responds to equity prices as it has in the past, even a substantial equity market boom would unlikely lead to a funds rate hike before 2012.

2. The Fed adopts a ?Bubble Policy?

Our results suggest that the Fed has ?walked the walk? and not responded explicitly to asset price bubbles during the last two decades. Following the financial crisis, however, the debate about whether the Fed should lean against asset  bubbles in the future has gained momentum. What is the likelihood that Fed officials will abandon the Greenspan doctrine and if so, what could their response to our hypothetical equity price boom look like?

It is tempting to interpret Kansas City Fed President Hoenig?’s dissent at the last two FOMC meetings as evidence that the Fed?s thinking on asset prices may be changing. He voted in favor of removing the language on keeping the funds  rate low for an ?extended period? because he worries about ?the buildup of financial imbalances.? But while some other members of the FOMC have also signaled a willingness to rethink the Greenspan doctrine, we see little evidence that Fed officials are about to adopt a full-blown ?bubble policy.?4

Nonetheless, let us assume for a moment that Hoenig could somehow convince the rest of the FOMC to abandon their long-held reservations against a bubble policy? how soon would they hike in response to our hypothetical equity price boom? Finding an answer to this question requires making two bold assumptions? and hence can serve for illustrative purposes only.

First, we need to define what we mean by a bubble. For simplicity we treat as a bubble the deviation of the ratio of the S&P price index to the 10-year moving average of earnings from its long-run value. Exhibit 5 plots this measure, suggesting that S&P valuation is currently broadly in line with historical norms and was most overvalued by 134% in 1999Q4 and 45% in 2007Q3. On this measure, our assumed equity boom would result in a valuation of 77% above average at end-2011. (We assume 7% growth in earnings.)

Second, we need to assume how the Fed might respond to this bubble. Somewhat ironically, we think the best way to calibrate this hypothetical response is to consider the academic work of its greatest critic: Chairman Bernanke. In his simulations he assumed that the central bank would raise the policy interest rate by 100 basis points for every 10% increase in equity prices above fundamental value (in addition to responding to expected inflation). In practice, such a response appears unreasonably large; for example, our valuation measure would imply that the Fed should have hiked by an additional 1340 basis points in 1999Q4! For illustrative purposes, we will therefore assume that the Fed would move somewhat toward Bernanke?s parameters and respond to our equity price boom by raising the funds rate by 25 basis points for every 10% deviation from ?fair value? in addition to responding to the growth in equity prices as prescribed by the Greenspan doctrine simulated above.

Exhibit 6 shows our results. First, we see that if the Fed had followed our bubble policy in the past, they would have implemented a tighter policy during the equity price booms of the late-1990s and mid-2000s. For example, our results suggest that the fed funds rate should have been raised to 8.8% in 1999Q4, well above the 5¼% actually implemented at the time. A ?bubble pricking? Fed would have raised interest rates somewhat more aggressively between 2004 and 2005 also; however, the difference is less marked as S&P 500 valuations? unlike house prices?were only slightly above historical norms.

Second, Exhibit 6 explores the robustness of our zero funds rate call going forward. Using the Fed?s forecast, the results suggest that a bubble policy would lead the Fed to hike the funds rate in 2011Q4. Clearly, this is much earlier than the Greenspan doctrine would suggest. But despite our very aggressive equity market assumptions, it is still a long way off ?and, of course, even more so with our own forecasts.

If you rushed to the conclusion, go back and reread this piece because it is actually important. In essence, what Goldman states is that no matter what happens with assorted bubbles, with asset price inflation, and with the stock market, the Fed will assume that the economy is be improving as a function of the stock market, but that any improvement will be based on the stock market… Uh… Yes, it basically means that no matter how much better the economy “may” get, no matter to what levels the S&P rises (even if does one assume that the market does determine the state of the economy… why not – we do live in a Banana republic now), the Fed will be convinced that the two are connected and in no way a function of monetary policy. By the time the Fed funds rate is lowered, the economy and the market will be at the plateau of the terminal bubble, whose implosion will be uncontrollable and make the 2007 housing and credit market bubble collapse seem like amateur hour.

  1. 1. For inflation, Exhibit 3 reports the forecasting gain compared to using a ?Phillips curve? relationship, which explains inflation by past inflation and economic slack. For the unemployment gap, we compare the forecast gain to using only past values of the unemployment gap. While we focus on the ?in sample  forecasting gain here, we obtained similar results for ?out-of-sample? forecasts.
  2. 2. See James Stock and Mark Watson, ?Forecasting Output and Inflation: The Role of Asset Prices?, Journal of Economic Literature, Vol. XLI, 2003.
  3. 3. Statistical analysis confirms a significant link between asset prices and the Fed?s expectations of future inflation and unemployment (not shown).
  4. 4. See, for example, Donald Kohn, ?Homework Assignments for Monetary Policymakers?, Remarks at the Cornelson Distinguished Lecture, March 24, 2010.

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