Housing Bubbles, Interest Rates, the Taylor Rule, and Central Bank Folly

November 7, 2012

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Flooding the world with cheap credit leads to misallocations of capital and asset bubbles. The Taylor rule is one measure of where interest rates should be, flawed as it is. It’s based on “potential GDP,” which is mutable and subject to considerable debate, and “inflation,” which varies considerably depending on what measure is used.

The esteemed James Grant had this to say on the Taylor Rule:

Google “Taylor Rule,” and you will see that the two important determinants of a Taylor-compliant funds rate are the so-called output gap and the measured rate of inflation. The output gap is the difference between what the country could be producing at full employment and what it is actually producing. It’s a contrivance, a made-up number, and it may or may not give fair warning of looming trouble in prices or credit.

Amusingly, the Federal Reserve bases the “output gap” on an average GDP taken during bubble years. For the inflation gauge used in the Taylor rule, it’s safe to assume few if anyone is seeing prices rise as low as the Consumer Price Index or PCE.

Nevertheless, it is one measure that’s at least “incrementally” superior to the “PhD” standard, as Grant likes to say.

As a practical matter, Hott and Jokipii (2012) used the Taylor rule in their study of real estate bubbles, finding that “keeping interest rates too low can explain up to 50% of the overvaluation of the property market in these countries.”

As you can see, central banks have violated the Taylor Rule in perpetuity, blowing bubbles across the world, and are attempting to do so again:

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Taylor rules and monetary policy: a global “Great Deviation”? ~ BIS

Housing Bubbles and Interest Rates – Voxeu

Goldbugs for Obama ~ Grant’s Interest Rate Observer

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