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Prospects daily: Greek bonds receive lukewarm response from market
March 2010
Prospects Weekly: Durable exports up, capital flows up in early 2010, USD's real rate relatively stable
| Japanese and U.S. export volumes rebounded in January on heightened demand for capital goods and durables, possibly creating some traction for job growth. While capital flows for 2010 through February have rebounded compared with 2009 (almost twice as high), they remain sharply compressed compared with the first two months of 2008 and 2007, largely reflecting anemic bank-lending. In contrast to U.S. dollar cross-exchange rates, which have been volatile since the onset of the crisis, changes in real effective exchange rates (REERs) have been more stable and have followed divergent trends tied more to domestic factors. The USD has appreciated 4.5% in REER terms since pre-crisis August 2008. Commodity exporter REERs have generally appreciated, while China’s currency has depreciated a modest 1.7%. | |
| High-income country exports and production are stepping up, as countries find receptive markets for capital goods and durables. Strong demand in China and Asia spurred a surge in Japanese export volume growth to 40% in January (y/y) following a decline of 22% in the third quarter of 2009. In similar fashion, U.S. exports registered 15.6% gains (y/y) helping to boost manufacturing output, with glimmers of employment growth on the horizon. For developing countries as a group, exports increased 32% in December (y/y). Despite robust growth, trade remains 27% and production 18% below their respective levels in 2007. |  |
| Total capital flows for the first two months of 2010 are up 48% (y/y), although they remain 47% lower than in 2007 and 23% lower than in 2008. Bank lending remains weak—underscoring that bank recapitalization is a lengthy process. After a barrage of issuance in January, bonds faltered in February, reflecting a seasonal hiatus and Greece’s debt crisis. Although bond issuance slowed in February, the pipeline remains full, with many sovereigns announcing plans to issue in coming months (e.g., Russia, Poland, Romania, Ukraine, and Albania). Indeed, issuance picked up during the first three weeks of March, with $13billion placed. |  |
| Real effective exchange rate (REER) developments reflect country specific factors. Despite heightened volatility in the nominal value of the U.S. dollar against most currencies, the USD REER has been relatively stable, having gained 4.5% since just before the crisis in August 2008. In the Euro Area, Germany’s REER has appreciated little despite the sometimes wild fluctuations in euro/dollar cross rates over the last two years. The currencies of commodity exporters (e.g. Brazilian real and Indonesian rupiah) have rebounded- unwinding much of their 2008 losses that were precipitated by declining commodity prices and the financial crisis. After appreciating sharply in the immediate wake of the crisis, China’s REER has since depreciated. As of February 2010, it was a modest 1.7 percent lower than its pre-crisis level, but still 18 percent above its level in July 2005 when China initiated the crawling peg regime that was abandoned during the financial turmoil of 2008. |  |
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Confronting uncertainty
The Economist this week led with this subheader: Action on climate is justified, not because the science is certain, but precisely because it is not. The underlying argument is that immediate action is akin to taking an insurance policy—you can’t wait until you have hard evidence in hand, because by that time, you can no longer protect yourself against a catastrophe.
This stresses an important point that nevertheless is often forgotten: Policy makers always make decisions under uncertainty. Only under special circumstances can they assume certainty equivalence, which would allow them to ignore uncertainty around central projections. But in most cases optimal decisions cannot be based solely on a central forecast. The character of decisions can change dramatically if uncertainty has to be explicitly taken into account. For example, it might be optimal to opt for policies that work relatively well in all possible scenarios. These are so-called no-regret policies. Or it can be optimal to follow cautious policies that prevent extreme scenarios. Taking uncertainty into account can also lead to the conclusion that you have to act soon (to prevent extreme scenarios) or, on the contrary, that it is optimal to postpone decisions (until uncertainty is reduced).
The challenges associated with uncertainty go far beyond these examples of optimal government policies. I realized that last week when I joined the final session of the workshop Economic and Environmental Consequences of Large-Scale Biofuels Expansion, organized by Dominique van der Mensbrugghe and Govinda Timilsina. The workshop brought together research that was sponsored by the Knowledge for Change program and based primarily on simulations using our ENVISAGE model (Environmental Impact and Sustainability Applied General Equilibrium Model).
The workshop focused on the economic viability of biofuel production, on the consequences for food prices, and how that all would be influenced by changes in policies and changes in oil prices. The closing discussion stressed the crucial role of uncertainty. Even if biofuel production is on average economically viable, there might be significant periods during which production is not profitable. Even if in the long run biofuel production does not threaten food supply, it can do just that in the short run.
I came away with two conclusions from that discussion. First, governments should not only take uncertainty into account when they design their policies, but they should also aim to reduce uncertainty for other agents by making their policies stable and predictable. Second, modelers should try to deal better with uncertainty. Not only by designing alternative scenarios, but also by exploring how unpredictable short-run volatility can influence individual behavior and market behavior.
So, uncertainty is a call for action, not only for policy makers as The Economist rightly observed, but also for modelers.
Prospects Weekly: Protectionism muted, FDI plummets in 2009, global oil demand now rising
| After declining 30% between September 2008 and March 2009 (values), global trade is growing very rapidly. And, while there was an uptick in trade protectionist measures in 2009, thus far it has been relatively muted. New estimates suggest that net FDI flows to developing countries declined 35% in 2009, posting the sharpest contraction in over 20 years. Nevertheless, FDI flows were more resilient than private bank-lending that plunged 134% in the year. Mirroring the recovery in global activity, global oil demand turned positive in Q4-2009, led by robust demand in China. Oil market conditions have continued to tighten on falling stocks and rising demand, buoying crude prices. | |
| Protectionism remains largely muted, according to a recent WTO/UNCTAD/OECD report—although the number of restrictive trade measures reported since October 2008 sharply exceeds liberalization measures by nearly 10:1 (374 vs. 39). The relatively modest rise in protectionist measures reflects the reaction to the rapid and sharp plunge in trade activity with the onset of the crisis. Given the current rebound in trade—with global exports rising by 21% (y/y) in value and volume terms in January 2010—much worsening of protectionism is not expected. Notably, initiation of antidumping investigations by G20 countries contracted 21% in 2009, although given lags between initiation and imposition of trade remedies, a backlog of investigations could raise the number of barriers imposed in 2010. |
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| While global net FDI inflows posted a rebound since their trough in Q1-2009, they contracted an estimated 40% overall in 2009. FDI flows to developing countries (LMICs) fell by estimated 35% in 2009, and even China recorded a record 30% drop in FDI flows to an estimated $95bn. In 2010, net FDI flows to LMICs are expected to grow 30%, with Asia continuing to receive the lion’s share. In coming years, private capital flows to LMICs are projected to continue to recover to levels witnessed during the late-1990s and early-2000s, but not to levels witnessed during the per-crisis boom—as capital is expected to be less abundant and more expensive, due to the reversal of nontraditional central bank easing and increased financing needs in high-income countries, balance sheet consolidation, and tighter regulations. |  |
| Global oil demand turned positive in Q4-2009 after falling for five consecutive quarters, buoying oil prices. While OECD demand remains negative, the pace of decline has moderated and is projected to turn positive in Q2-2010. Among non-OECD countries, demand growth has been concentrated in China, with Q4-2009 up a resounding 17% (y/y). This reflects a level shift (not a change in trend growth), as more than half of this increase is tied to capacity expansion of Chinese petrochemical feedstock and should moderate in the future. Continued tightening of market conditions has supported higher crude oil prices (World Bank average), which have traded between $70-80/bbl for over five months. And, the futures curve has flattened, suggesting that markets see price stability moving forward. |  |
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After destocking comes restocking
For the third day it is very sunny here in Washington DC, after we had our fair share of rain over the weekend. Spring is coming and the popular saying that “after the rain comes the sun” is once again firmly confirmed.
The economic equivalent of this saying might well be “after destocking comes restocking”. Destocking was a crucial factor in the collapse of production during the crisis, as it is during every recession. And restocking is a key element during the recovery, albeit in a complicated way. So, it is not a surprise that the world economy is waiting for that restocking.
As demand fell, and uncertainty increased, inventories were sharply reduced during the crisis. That meant that producers met part of the remaining demand by depleting stocks. As a result, production fell much faster than demand. Partly because of the destocking the rain turned into a torrent.
From there on the inventory dynamics became (as usual) a bit more obscure, but actually quite fascinating. Even as the rundown of inventories continued, the negative impact on production growth quickly dissipated. That is always surprising, but the explanation is based on a simple mathematical rule: growth of production depends on the change in stockbuilding, or the change in the change of inventories. If the inventories continue to fall, but at a more moderate rate, then the impact on production growth actually turns positive. That is what indeed happened during the latter part of 2009 in many countries.
Korea provides a nice illustration. The numbers are shown in two graphs below. The first one shows the level of inventories and the stockbuilding (i.e. change in stockbuilding). The level of inventories is actually not observed, but it is easy to derive at a plausible estimate. The graph shows the sharp decline in inventories at the start of the crisis from around 50% of GDP to 35% of GDP. Stockbuilding was strongly negative, but the rate of decline in the inventories was slowing during the last two quarters of 2009.
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The (perhaps surprising) impact on the growth of Korea’s GDP is shown in the second graph. First a sharp negative impact, but then GDP growth was temporarily boosted as the destocking slowed. The wait is now for an additional boost in GDP growth. That one comes when destocking completely stops and restocking starts. That is when the real sun breaks through the data. I will follow this story in this blog as more data becomes available. In the mean time, let me enjoy the sunshine in Washington DC.
Prospects Weekly: Record high auto sales, G-20 face sharp fiscal adjustment, emerging market bond spreads down but yields up
| The rebound in global output during the second half of 2009 was buoyed by “cash-for-clunker” incentive programs that propelled global car sales to a record high. As these programs have begun to expire, the pace of industrial production growth is expected to moderate in the coming months. High levels of public debt will require large—although not unprecedented—fiscal adjustments in many high-income countries over the next 20-years. Emerging market bond yields have climbed since late-2009, due to higher yields on benchmark U.S. Treasuries, although their spreads have remained broadly stable during the period. As U.S. bond yields increase further with the reversal of the Federal Reserve’s monetary stimulus measures, emerging market bond yields are likely to rise as well. |
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Auto sale incentive programs supported record high global auto sales and a rebound in industrial production. Some countries that witnessed a marked revival in manufacturing activity in the second half of 2009 had car sale incentive programs. As these programs have recently expired in the U.S., Korea, Australia, and in most Euro Zone countries—or are about to in Brazil, India, and the U.K.—momentum growth in industrial production is expected to slow in the months ahead. This, alongside adverse weather conditions, appears to have been a contributing factor in the recent loss of momentum in industrial output in Germany. By effectively front-loading demand, these programs pushed global car sales to an all-time high of 54.3mn units in January 2010 (seasonally adjusted annualized rate, JP Morgan).
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Many G-20 countries face significant fiscal adjustment. High government debt and aging populations will force many high-income countries (HICs) to undergo sharp fiscal consolidation over the next 20-years. The IMF estimates that—to regain a sustainable 60% debt-to-GDP ratio—the HIC G-20 will need to adjust primary fiscal balances (excluding interest payments) from a deficit of 3.5% of GDP in 2010 to a surplus of 4.5% by 2020 and then maintain a 4.5% surplus through 2030 (i.e., cut spending or raise revenues by an average of about 6% over a 20-year period). While challenging, such large adjustments are not unprecedented. For most developing countries (LMICs) no such adjustment will be required, as their debt ratios are much lower—40% in 2010 for the LMIC G-20 vs. 107% for the HIC G-20.
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| Emerging market bond spreads have declined from recent peaks in October 2008, although they remain about 80 basis points above the level posted during the 18-month period ending in June 2007. While bond spreads have been broadly stable since October 2009, benchmark U.S. Treasury yields have increased 50 basis points since end-November, pushing up the cost of capital for developing countries. Looking ahead, as non-traditional monetary stimulus measures (which have kept down medium-term interest rates in the U.S.) are withdrawn, developing country bond yields are expected to rise further—although perhaps not on a one-to-one basis with the rise in the cost of U.S. bonds. |  |
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Why We Should Favor (Slightly) Less Efficient Financial Markets
Lost in many of the post-crisis financial reform proposals to rein in destructive financial innovation---such as calls to ban naked CDS, establish centralized clearinghouses for derivatives, and eliminate high-frequency trading---is the broader issue of whether these innovations could actually enhance welfare. The Economist recently took up the challenge by hosting a debate between two academic bigwigs: Brown's Ross Levine, an empirically-oriented financial economist who has spent much of his career studying the relationship between financial development and growth, and Columbia's Joe Stiglitz, an economic theorist who won the prize for his pioneering work on asymmetric information, including seminal work on credit and financial markets that was cited by the Nobel committee in its award of the prize to Stiglitz.
Much of the disagreement between the two, where it exists, boils down to their respective views of whether these innovations spur an expansion of the real economic pie. The tradeoff appears to be between the gains from that result when financial innovations help establish the efficient market-clearing price level, which in turn raises welfare (by the second fundamental theorem), versus the social value of these innovations, many of which appear to have only served to contribute to financial sector bloat and increase banker compensation. This is the efficiency versus equity debate all over again, recast for modern finance.
I have little to add to their excellent arguments on each side, although I'd note that the debate did drift a little from the motion ("This house believes that financial innovation boosts economic growth") to a debate over whether recent financial innovations are good for economic welfare. To which I would point out that this raises three slightly more subtle issues about the nature of recent financial innovations.
First, one needs to concede that it is virtually impossible to figure out, ex ante, which innovations would actually generate real economic growth, versus those that mainly serve to transfer resources between agents (and so are neutral for the aggregate economy). Given this fundamental uncertainty, many would argue that it is perhaps best to leave Mr. Market to figure out the innovations are genuinely beneficial---such as venture capital financing---and weed out those---such as CDO-squareds---that are essentially not (an analogous argument to the case against "picking winners" in industrial and trade policy).
Second, this market-driven selection of beneficial financial innovations does not really require the best and the brightest to work in finance. After all, hyperintelligent agents are neither necessary nor sufficient to guarantee financial market efficiency. They are not necessary, since even zero intelligence traders have been shown in laboratory markets to be able to achieve (allocative) market efficiency. Nor are they sufficient, since complex financial products are stupendously difficult to price, and can outwit even the smartest traders equipped with the most powerful computers (one could also make a snarky remark here that the cluelessness of some bankers as to the operations of their own institutions prior to the crisis probably casts doubt that those working in the financial sector are, in fact, the best and brightest).
Third---and most important---even if it were the case that increased efficiency does enhance welfare in a hypothetical frictionless world, there may be complications in reality that call the efficiency gains into question. Consider, if you will, the idea that hyperefficient pricing (with millisecond speed) is desirable because it enhances price discovery and contributes to overall liquidity. Although clearly beneficial from the point of view of improving the efficiency of the financial market in question, it is less clear whether this is immediately good for complementary markets, such as markets in the real economy that utilize financing for production purposes but sell their output in slower-moving goods markets (or hire workers from even more slowly-adjusting labor markets).
More generally, welfare gains to allocative efficiency are only realized when resource reallocations are complete. But if sticky prices and wages mean that these reallocations take place relatively slowly, then having allocations "outrun" resource transfers could raise the short-run welfare losses that result from unemployed resources in the real economy. While gains from intertemporal trade are ultimately obtained from a well-functioning financial market, the relevant welfare criterion would appear to be an evaluation of the long-run gains from the efficient allocation of resources, versus the aggregate short-run losses from temporarily unemployed resources. Throw in the fact that increased volatility is likely to be detrimental to welfare, and the case for hyper-efficient financial markets becomes even harder to make.
At the end of the day, a large body of evidence does in fact tell us that financial development is good for economic growth and welfare. However, the optimal level of financial development in any given economy may well be endogenous. Developing countries with immature financial sectors may benefit from a more measured, tiered approach as they move toward greater financial liberalization. A full-speed ahead strategy is likely to impose unnecessary adjustment costs on countries that are neither ready nor require the most sophisticated financial instruments. Developing countries can also take advantage of second-mover advantages and benefit from demonstration effects in deciding whether to approve or adopt a particular class of financial products.
Update: Randall Dodd, writing in the March 2010 issue of Finance and Development, makes the case that three recent forms of financial innovation actually lead to a decrease in efficiency.
Global Recovery Remains on Track... For Now
So far, the indications are that the global economic recovery remains on track and broadly in line with Global Economic Prospects (GEP) 2010 projections. In high income countries (HICs), the (annualized) Q-o-Q output rebound during the final quarter of 2009 has been particularly strong in the US (5.9 percent), Japan (4.6 percent) and Canada (5 percent). This has masked weaker growth performances in other (HICs) such as the UK (even as the 1.1 percent growth was the first positive number after six straight quarterly declines), Germany (back to zero growth), and Italy (-0.8 percent).
Within the East Asia and Pacific (EAP) region, the Chinese fiscal stimuli have been instrumental in the Chinese recovery, which started around mid-2009. This has spilled over to the rest of the region and growth has accelerated significantly towards the end of 2009, with growth particularly strong in Thailand and Malaysia.
In the Europe and Central Asia (ECA) region, growth remains weak with some countries recording a double-dip as growth fell back into negative territory. Latvia and Lithuania, for instance, recorded negative growth rates in the fourth quarter of last year. However, in the case of the latter, the slip into negative growth territory (-6.2 percent) is off a high base (24.3 percent) in the third quarter.
In Sub Saharan Africa, the gradual recovery in South Africa gained further momentum, but continued political uncertainty in Kenya shifted the country back into recession. In other developing countries, the lack of formal quarterly GDP data is hindering the assessment of economy-wide trends. But from the limited data available, it seems that the developing country recovery remains on track. For instance, developing country exports has risen by 20.3 percent in the year to December (nearly double the 11.5 percent increase registered in high income countries), while the developing country imports surged by 24 percent during the same period - reflective of surging domestic demand in emerging economies. Likewise, industrial production in developing countries has risen by 13.1 percent and with the exception of the Latin America and Caribbean (LAC) region, have registered double-digit growth rates.
Growth prospects are similarly differentiated. For ECA, as financial markets continue to assess the (relative) sustainability of debt and deficits around the globe, ongoing uncertainty will hamper recovery. For the HICs and EAP, a moderation in growth is expected during the course of 2010, as fiscal stimuli unwind and as the inventory cycle abates. Exceptionally bad weather conditions in some Northern Hemisphere countries may also be a drag on growth in the first quarter of 2010. Furthermore, given the high base created by the exceptionally strong recovery during the last few quarters, growth is expected to moderate in the coming quarters.
Finally, the data indicate that developing countries have been able to recover more quickly (and time will tell whether also in a more sustainable way), as they followed sounder economic policies, including better fiscal and regulatory discipline, going into the financial crisis.
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The good, the bad, and the ugly imbalances
In a recent IMF Staff position note Olivier Blanchard and Gian Maria Milesi-Ferretti provide a useful classification of current account imbalances. They argue that deficits and surpluses on current accounts are "good" if they reflect optimal allocation of capital across time and space. That is the case, for example, when savings ratios differ across countries because of different ageing profiles or when investment ratios differ because of different productivity trends.
However, imbalances are “bad” if they reflect distortions that cause suboptimal saving or investment behavior. These distortions may range from lack of social insurance (creating too much household savings) or poor firm governance (creating unwarranted corporate savings) to excessive public borrowing or excessive build up of foreign exchange reserves. A widespread distortion is that borrowers commonly underestimate the volatility of capital flows and the related risks and consequently over-borrow.
So far, so good. But, as B&M acknowledge, it is far from easy to determine the character of actual imbalances. Were global imbalances over the last decade good or bad? B&M provide an interesting assessment of the past and (predicted) future imbalances. And it shows indeed that such an assessment is not straightforward, as also their judgment is both defendable and debatable. But let’s not go into that now.
Let me state a more obvious point: You don’t have to be a fan of spaghetti westerns (but who isn’t?) to realize that something is missing in the analysis. If there is a good one, and a bad one, then there must be an ugly one, too. Which dimension is missing in the paper of B&M?
In my opinion the missing dimension is the imbalance between global demand and supply of goods and services. If a country runs a current account deficit (that means that, for either good or bad reasons, spending exceeds income) then that imbalance can easily get ugly if global spending already exceeds global production capacity. Conversely, in a situation of insufficient global effective demand current account surpluses are likely the ugly ones. More specifically, over the last decade the U.S. current account deficits (underpinned by ample creation of liquidity) would be ugly if there was already more than enough effective demand in the world. The surpluses in some European countries, in oil exporting countries, and more recently in China would be ugly if there was a chronic lack of effective demand.
To determine which imbalance was ugly we take the World Bank’s measure of global capacity utilization and add that to Figure 1 in B&M’s paper, which contains current account imbalances over time. (see chart below)
The increase in U.S. deficits since 2003 coincided with a tightening global real economy, as reflected in our measure of global capacity utilization, which could also be illustrated with low unemployment numbers and which ultimately showed in sharp increases in commodity prices. In that period the deficits looked a bit uglier than the surpluses. That changed obviously in 2008 with the global crisis. Surpluses in oil-exporting countries and in China came down sharply, but they became uglier too, because concerns dramatically shifted to lack of global effective demand.
This third dimension not only provides a more complete description of the character of imbalances, it is also a crucial element of the policy debate. U.S monetary or fiscal policy should tighten if one worries about the U.S. current account deficit, but also if one worries about too much global demand. China should stimulate domestic demand if one thinks that China’s current account surplus is unwarranted, but also if one worries about insufficient global demand.
In that regard the discussion about exchange rate policies is an intriguing one. It is often presented as a way to reduce current account imbalances. The story goes as follows. If a country stimulates domestic demand, which would decrease its current account surplus, then the price of domestic goods must rise relative to the price of foreign goods. To prevent domestic inflation, a smooth way of achieving that relative price change is through appreciation of the nominal exchange rate. (By the way, as they compare two possible future scenarios, B&M argue that if in China increased domestic demand is not accompanied by appreciation of the currency, then the reduction in the current account surplus will not occur. That is unlikely. More likely is that it would lead to domestic inflation.)
In that sense the exchange rate is related to adjustments in current account, albeit in an indirect way.
However, the situation is very different if we see exchange rates as an independent policy instrument, independent of more fundamental changes in domestic demand. Then changes in nominal exchange rates have a lot more to do with stimulating or slowing down the economy. For example, an appreciation of their currency does not necessarily decrease a country’s current account surplus. An appreciated currency makes a country less competitive and production will slow. As a result, the investment ratio will fall and a current account surplus has a tendency to increase. Conversely, countries can stimulate their economy through depreciation, which could create a boom, higher investment rates, and a decrease in their current account surplus, or an increase in their deficit.
From a global perspective, merely changes in exchange rates do little to stimulate or slow down the economy. The advantage of one country is the disadvantage of another country. That is why a focus on changes in domestic demand is more important than changes in nominal exchange rates, not only to correct good or bad current account imbalances, but also to restore equilibrium in the global markets for goods and services, and thus make the world economy less ugly.
Source: World Bank and IMF
Do Taylor Rule Deviations Contribute to Asset Bubbles?
The notion that systematic Taylor rule deviations has a role to play in the real estate bubble in the United States is an issue that has been rigorously debated---see John Taylor (PDF) and Marco del Negro and Christopher Otrok for opposing views---but broader evidence at the cross-country level is relatively scarce. One exception is the working paper by Rudiger Ahrend, Boris Cournede, and Robert Price, economists based at the OECD's economics department.
What do the data say? Focusing only on three major economies---the United States, Japan, and the Euro area---there does appear to be a systematic relationship between Taylor rule deviations and the development of bubbles in housing markets (see figure) (subject to the caveat that the patterns for the euro area only really hold post 2003; then again, the data may be noisier since the synthetic index shown only uses indexes from two markets in the euro area). Regardless, ocularmetrics suggests that we cannot rule out the possibility that the two factors are related (for the causality mafia: of course, correlation does not imply causation, but the chart does use 2-period lagged house prices, so at some very superficial level we are taking into account the possibility of reverse causality).
Notes: Graph of Taylor rule deviations (lines) and 2-quarter lagged house price indexes. Index for euro area averages index for Spanish and Irish house prices, the two major "bubble" markets.
That said, it should be noted that Bernanke---in his defense of Fed interest rate policy---did not claim that there was no relationship between housing prices and Fed policy on short-term interest rates (something that Greenspan decried on the basis of the disconnect between Fed-influenced short run rates and long-term mortgage rates). Rather, his argument was that even if low interest rates were a contributing factor to the bubble in house prices, the much larger magnitude of the rise in actual house prices would fall outside the predicted bounds (of an in-house VAR model). Something, therefore, must be the primary contributor to the housing bubble: according to him, that something turns out to be capital inflows.
What about other asset prices? Here, the picture is murkier. Notwithstanding the much greater difficulty of identifying what constitutes bubbles in equity markets, the clear negative relationship in the earlier figure does not carry through (see figure). In some ways, this is a little less surprising. Stock markets are notoriously difficult to forecast, and while investment in housing is more likely to respond to the current shape of the yield curve, equity prices incorporate all sorts of information, both publicly and non-publicly available. There are even those who have shown that economic growth is largely irrelevant in determining equity returns.
Notes: Graph of Taylor rule deviations (lines) and contemporaneous equity indexes.
While I would hesitate to forward a purely Austrian interpretation of these events---there are, after all, notable problems with the theory as it stands, especially with respect to the implied anticyclicality of consumption growth (which is inconsistent with business cycle facts) as well as an implied continual irrationality among investors---one is nonetheless led to wonder about the mechanisms that lead short term interest rates to exert an impact on housing booms. Is it recent financial innovation, in the form of mortgage-backed securities (if so, why did correlations between short and long rates fall from the 1990s onward, when MBS were in their prime)? Is it sticky prices, via the interest rate channel (if so, why do we see so little inflation response throughout the 2000s)?
Importantly, there are lessons here for developing countries seeking to manage their domestic monetary policy. Central bankers would do well to keep an eye on their respective implied Taylor rule rates for their respective economies as they adjust their own policy rates. However, in small open economies that are susceptible to sudden stop phenomena, practical Taylor rules may also require incorporating the open-economy effects that capital flows have on the real exchange rate. This is especially so given the unexpected surge in capital inflows experienced by emerging markets in 2009.