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Do Taylor Rule Deviations Contribute to Asset Bubbles?

Jamus Lim's picture

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.