Does The Fed Have The Right Information? Reprinted

The following post is a reprint of my January 4, 2008, post on another, short-lived blog of mine. I am reprinting the post because 3 years later there is still a need for solutions to our economic problems of slow GDP growth and high unemployment and there is still an ongoing debate as to what are the best monetary and fiscal action policies to follow:

January 4, 2008

Does the Fed have the right information?

Does the Federal Reserve have the best information to control inflation and maintain employment growth? Has the Fed been too passive in accepting the current supply of economic data?

The Fed, like the rest of us, relies on published economic data, surveys, and anecdotal evidence to assess the state of the economy, and most of that data reflects past or concurrent economic indicators of the health of the economy. The Fed does not have magical powers or a crystal ball to tell it what will happen next. The Fed does not have a secret recipe that makes it a better predictor of the future of the US economy than ordinary investors. But, the Fed does attempt to maintain a sustainable level of economic growth that will cause neither inflation nor excessive unemployment based on all available information.

In fact, the Fed and many economists look at bond yields, including the slope of the yield curve, and stock market prices to assess future GDP because these prices contain investor expectation data about future interest rates, inflation, and economic growth.

But is the Fed too passive in monitoring the current supply of information. Why doesn't the Fed in conjunction with the Treasury create a government issued financial instrument that would reveal more about the future of the US economy than is currently available?

For example, Treasury could issue a GDP linked bond whose semiannual coupon payment would be a fixed percentage of the most recent nominal GDP number at the time of coupon payment. This would force investors, in pricing the bond, to incorporate explicit expectations about future GDP. The price of the bond would reflect the present value of all future GDP growth over the period until maturity. And because the bond would be discounted (present valued) based on nominal interest rates, the current price would be a measure of total real (inflation adjusted) GDP over the life of the bond.

GDP linked treasury bonds, through analysis of embedded forward rates, would allow the Fed to see in what future time periods over the future life of the bonds that the market was predicting a slow down in economic growth. It would also allow the Fed to see if its policies were merely time shifting future economic growth into other periods without actually creating any overall growth in the economy.

Over time, the premium on the rates paid on these bonds over plain treasury bonds would allow for an analysis of the inherent risk of the US economy. And whether this risk changes over time.

Changes in the price and future embedded rates of GDP linked bonds would allow for an analysis of the effect of legislative and other governmental policies on US future economic growth. If the government introduces or discusses policies and there is an immediate decrease in the price of the bonds then clearly the policies are not good for maximizing future economic growth; although, they may have other benefits.

Having a GDP linked treasury bond would allow the US to maximize future economic growth. The bonds would also allow information about future economic activity to be discerned and assigned to a specific future time period. GDP linked bonds would allow the populace to see if our politicians are doing positive things for the future health of the US economy after their terms in office end before we actually are in those time periods.

The Fed does have very good mathematical economic models to project future economic growth. However, like all models, they work only as long as the relationship among the variables remains static or predictable. So for example, one of the Fed's models mistakenly predicted that we should have been in a recession for the last several years because it used historical relationships about the relative investment in fixed capital versus intellectual property and missed the increase investment in intellectual assets. When correcting the model for the actual relationship between intellectual and fixed property investments over the last several years, the model accurately predicted the actual historical economic growth, but failed on a prospective basis because of the change in the relationship of the variables.

The Fed should take a more active role in deciding what information it can obtain from the investment markets, design instruments accordingly, and work with Treasury in issuing and creating liquid markets for these information designed securities.

Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble [Weblink updated].

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:

1. a significant and long-term decline in household formation.
2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
3. an increase in adult children living in their parents home (including after marriage or cohabitation).
4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
7. a decline in both household income or the expected growth rate of household income.
8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
10. a substantial expected increase in real estate taxes.
11. other possibilities that affect the economic value of a home that I have not mentioned.

Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf [The Office of Federal Housing Enterprise Oversight (OFHEO) no longer exist and I am unaware of an updated weblink to the paper.]

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.