Monetary Policy, Bubbles, and Goldilocks
Emerging signs of stronger economic activity and the
Federal Open Market Committee (FOMC)’s second
round of quantitative easing (QE2) have raised concern
among some analysts that expansionary policy might
be causing bubbles in financial and commodity markets—
bubbles that might harm the economy if they burst.
for bonds, equities, and commodities have increased sharply
since late August: The Reuters Jefferies/CRB weekly futures
commodity price index increased by 22 percent (in U.S.
dollars) through the week of November 9 (but fell sharply
the following week), oil prices by 22 percent, the Economist
food-price index by 20 percent, the Russell 2000 Index by
22 percent, and the broader S&P 500 Index by 15 percent.
Given these increases, the concern over bubbles is reasonable,
but it is difficult to distinguish beforehand the line between
aggressive (“just right”) monetary policy and overly aggressive
(“too hot”) monetary policy that generates bubbles.
Rapid increases in commodity and financial market prices
by themselves, however, are not reliable indicators of potential
bubbles because such increases also occur as part of
normal monetary policy.
How exactly does policy operate
in normal times when the federal funds rate is well above
zero? The path begins with a reduction in the target rate,
continues with changes in longer-term interest rates, and is
followed by increases in real economic activity.
low returns on short-term, low-risk investments prompt
investors to move to longer-term, higher-risk investments in
financial instruments, commodities, and durable goods.
In turn, bond and equity prices rise, decreasing corporate borrowing
costs and increasing household wealth. There also is
a price effect: Broad expectations of higher prices for goods
and services in future periods induce firms and households
to spend money now rather than later. And there are lags:
Increasing the production of residential and nonresidential
durable goods (including structures and durable equipment)
takes time. During this “time to build,”
2 both the size and duration of the difference between the contemporaneous prices of financial and real assets and their long-run values are larger, ceteris paribus, when monetary policy is more
aggressively expansionary and increases in aggregate demand
are stubbornly slow.
Eventually, as the economy rejoins its
balanced growth path, bond prices fall (yields increase) as
real interest rates and expected inflation increase.
Commodity price movements are more complex and involve
several factors. One factor is the potential success of expansionary
monetary policy: If economic activity expands, demand for
commodities likely will increase, pushing futures prices upward,
which, in turn, tends to increase current-period prices.
Further, some analysts have suggested the expansion of hedge funds and
similar investments over the past decade may have increased the
speed and volatility of commodity price changes.
3 A second factor is the decreased foreign exchange value of the dollar as
a result of aggressive monetary policy. Because most commodities
are freely traded in international markets, commodity prices
in U.S. dollars tend to increase as the dollar’s value against
other currencies falls. As James Hamilton discussed in his blog
on November 10, 2010, recent data show that changes in the
U.S. dollar price of oil closely approximate changes in the dollar’s
exchange value against our trading partners.
4 As long as the FOMC’s pursuit of highly expansionary policy
continues, households and businesses remain pessimistic, and
demand is sluggish, the potential exists for asset prices to deviate
from their long-run levels by large amounts and for long
Such increases per se are not bubbles but a commonplace
reaction of the monetary transmission mechanism. Yet,
monitoring of prices is essential lest future adjustments be misunderstood
by the public as part of the dynamics of aggressive
monetary policy. Whether bubbles have been generated remains
to be seen.
—Richard G. Anderson[/u]