Leamer writes:
Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. A modified Taylor Rule would depend on a long-term measure of inflation having little to do with the phase in the cycle, and, in place of Taylor’s output gap, housing starts and the change in housing starts, which together form the best forward-looking indicator of the cycle of which I am aware. This would create pre-emptive anti-inflation policy in the middle of the expansions when housing is not so sensitive to interest rates, making it less likely that anti-inflation policies would be needed near the ends of expansions when housing is very interest rate sensitive, thus making our recessions less frequent and/or less severe.
Here is the paper, try this link too.
This kind of talk makes me nervous. The Fed "matters" for at least two reasons. First, short-term interest rates affect the real economy. Second, Fed policy is a focal point in a noise trader game and also in a macro "should we expand or should we contract output?" multiple equilibria game. Given the second factor I am reluctant to strangle so many booms in the cradle. Furthermore, identified macroeconomic relationships become less stable the very moment a policymaker tries to act on them ("Goodhart’s Law," which is related to the Lucas critique).
We can’t reject unit root models (many of which suggest a gain in the growth rate is on average permanent, noting that "do not reject" is not the same as "accept"), so I say let her rip and don’t take the punch bowl away. Who knows what tomorrow will bring?
The bottom line: I didn’t feel comfortable in Leamer’s world. I would sooner say "Comovement IS the Business Cycle."
“This would create pre-emptive anti-inflation policy in the middle of the expansions when housing is not so sensitive to interest rates, making it less likely that anti-inflation policies would be needed near the ends of expansions when housing is very interest rate sensitive, thus making our recessions less frequent and/or less severe.”
Correct me if I’m wrong, but isn’t this exactly what Bernanke has tried to do over the past three years? Raise rates to pre-empt the implosion of the housing/mortgage/credit markets so that he could lower rates without fear of inflation when the day of reckoning finally came? If the the greenback hitting parity with the Canadian dollar is any indication, this appears to have failed.
Real estate-centric theories of the business cycle are nothing new. Take a look at this fascinating table by Mr. Fred Foldvary, Economist at Santa Clara University. From “The Business Cycle: A Georgist-Austrian Synthesis.” American Journal of Economics and Sociology 56 (4) (October 1997): 521-41.
I am not an economist, but a small business owner that cannot help but wonder if the world has changed and few have noticed. Small service businesses use mortgages to raise money while banks prefer tangeable assets. Any tampering with interest rates effects this. Here in New Zealand we currently have the highest rates in the western world. ‘Greedy Investors’ get the blame, but the damping impact on business is either well understood or buried in political rhetoric.
It seems to me the knowledge economy is as hamstrung in old-think as Europe was before limited liability companies were conceived.
I think we’re starting to get enough material and published research for a whole macroeconomic theory based on bounded rationality. And it teaches us that we’re screwed.
Based on Fehr’s work on strategic complementarities in beliefs, we learn that low inflation can be bad, because even a few workers’ failure to grasp the difference between nominal and real wages makes wages sticky overall.
As Leamer show, with housing prices, a combination of liquidity constraints, leverage, and irrationality also make housing prices sticky, especially in the absence of inflation.
So why not allow some inflation?
Oops, you can’t do that, because as “How the Inflation Illusions Killed the CAPM” shows us, high inflation leads people to undervalue stocks, because idiot stock analysts value stocks using nominal interest rates. So inflation then causes underinvestment in physical capital. D’oh!
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