The document discusses how inflation targeting by central banks in the early 2000s contributed to the development of a housing bubble and the 2008 financial crisis. Specifically, it argues that keeping interest rates too low for too long from 2002 to 2004 accelerated housing and private investment and the issuance of subprime mortgages. When interest rates rose sharply from 2004 to 2006, the housing bubble burst as highly leveraged households could no longer afford their mortgage payments, triggering an economic downturn. The crisis spread globally through the contagion of subprime mortgage-backed securities. Modeling used by central banks failed to account for the effects of fluctuating household debt on consumption.

1. Effects of inflation targeting misfiring on
development of housing market bubble
and its bursting in 2008 credit crisis
Author: George Perendia, LMBS
e-mail: george@perendia.orangehome.co.uk

2. Background:
The so called "years of
great moderation", the
years of relatively stable
and low inflation since
early 1980,
a period of reduction in
government spending and
period of the new inflation
targeting mechanism
providing
stable and
– low inflation (2%) and
– low interest rates,
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0
4
8
12
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24
50 55 60 65 70 75 80 85 90 95 00 05 10
R_FED_TGT
PI100*4
PRIME_R
R_INTRBNK
Inflation and interest rates: FED, Inerbank and Prime Loan
5
10
15
20
25
30
50 55 60 65 70 75 80 85 90 95 00 05 10
GC_PC_DFLT
Government spending per capita (deflated)

3. Background:
They were all but that!
in the long term, low
interest rates were a
green light for many:
– the consumers,
– the households,
– the investors, and
– the governments,
to start borrowing
excessively with
expectation of ever
low repay interest
rates!
30
40
50
60
70
80
90
100
50 55 60 65 70 75 80 85 90 95 00 05 10
PDEBT_PER_GDP_DFLT
8
12
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28
1985 1990 1995 2000 2005 2010
INV_REAL_EST_LNS_PERGDP

4. Background:
The more the households
borrowed,
the more they would consume
creating higher demand, and,
the resulting higher GDP output
enabled governments to borrow
and spend even more.
The low inflation was supported
by import of cheaper goods from
developing countries, and
the trade deficit was balanced
by government debt being sold
to the same, mainly exporting
countries of East Asia
whose foreign reserves
rocketed since 2002.15
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40
45
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GDP_PC
0
2000
4000
6000
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14000
50 55 60 65 70 75 80 85 90 95 00 05 10
GDP

5. Crisis at The Gate:
Many authors, in particular from
IMF background, argue that
increase in public debt
reduces prospects of growth
mainly due to the pattern of
resulting under-investment
caused by the investor
expectation of higher:
– long-term interest rates,
– future taxation,
– inflation and
– economic volatility
see e.g. Kumar M.S. and Woo, J
2010: Public Debt and Growth1,
IMF Working Paper, July 2010.
0
2000
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6000
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10000
12000
14000
50 55 60 65 70 75 80 85 90 95 00 05 10
GDP
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50
60
70
80
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100
50 55 60 65 70 75 80 85 90 95 00 05 10
PDEBT_PER_GDP_DFLT

6. Crisis at The Gate: As few authors show, in some
cases increased debt may be
beneficial for growth.
Traum and Yang (2009) show
that if increased government
debt was used to
– reduce capital gains taxes or
– for business investment,
then further investment can be
attracted (I.e. crowded-in)
instead of being discouraged
(and crowded-out),
leading to increase of GDP
see: Nora Traum And Shu-Chun S.
Yang (2009): Does Government
Debt Crowd Out Investment? A
Bayesian Dsge Approach;
0
2000
4000
6000
8000
10000
12000
14000
50 55 60 65 70 75 80 85 90 95 00 05 10
GDP
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40
50
60
70
80
90
100
50 55 60 65 70 75 80 85 90 95 00 05 10
PDEBT_PER_GDP_DFLT

7. Crisis and the Bubble Burst: Inflation mis-targeting
in spite of the rising inflation in
2003 and 2004,
the federal funds target rate
was lowered even further from
2002 to 2004 (left) and
the resulting, “real” fed. funds
target rate (lower left), i.e. the
rfft – π (inflation) was actually
around 2.5% below 0 in Q1 of
2004!
then it rose, from Q2 of 2004,
to nearly +3.5% by Q4 of 2006
and
stayed rather high throughout
2007.
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1985 1990 1995 2000 2005 2010
R_FED_TGT PI100*4 PRIME_R
-4
-2
0
2
4
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12
1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4

8. Crisis and the Bubble Burst: Inflation mis-targeting
Few authors showed that
lowering of federal funds target
rate from
– 6.5% in 2000 to a
– mere 1% by mid 2003
may have accelerated both
– the industrial and
– the private housing investment
and the sale of both:
– the prime and
– the sub-prime mortgages
see e.g.: Dokko, J., Doyle, B., Kiley, M.
T., Kim, J., Sherlund, S., Sim, J., and
Van den Heuvel, S.: Monetary Policy
and the Housing Bubble,; Finance and
Economics Discussion Series Divisions
of Research & Statistics and Monetary
Affairs Federal Reserve Board,
Washington, D.C. 2009
-4
-2
0
2
4
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8
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12
1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4
8
12
16
20
24
28
1985 1990 1995 2000 2005 2010
INV_REAL_EST_LNS_PERGDP

9. Crisis and the Bubble Burst: Inflation mis-targeting
Whilst US Fed (and Mr B.
Bernanke) reject that FED
facilitated the housing bubble
in contrast, J.B.Taylor (2007)
indicated that such “too loose”
monetary policy during 2003-
2004 period probably lead to
the extensive housing activity.
See: Taylor, John B. (2007).
Housing and Monetary Policy,
NBER Working Paper Series
13682.Cambridge, Mass.: National
Bureau of Economic Research,
December 2007.
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4
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16
20
24
28
1985 1990 1995 2000 2005 2010
INV_REAL_EST_LNS_PERGDP

10. Crisis and the Bubble Burst: Inflation mis-targeting
Gordon (2009) also points to
many similarities between
1927-29 and the 2003-06
bubbles, from
– highly leveraged (90%), low
interest loans for stock and
housing purposes
respectively, to
– the regulatory failures caused
by repeal of Glass-Steagall
Act.
see: Gordon,R. J. (2009). Is
Modern Macro or 1978 Era Macro
More Relevant to the
Understanding of the Current
Economic Crisis? Northwestern
University, September12, 2009
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4
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24
28
1985 1990 1995 2000 2005 2010
INV_REAL_EST_LNS_PERGDP

11. Crisis and the Bubble Burst: Inflation mis-targeting
They however note:
…“It is widely acknowledged
that the Fed maintained short
term interest rates too low for
too long in 2003 04, in the
sense that any set of
parameters on a Taylor Rule
type function responding to
inflation and the output gap
predicts substantially higher
short term interest rates during
this period than actually
occurred… thus indirectly the
Fed’s interest rate policies
contributed to the housing
bubble”-4
-2
0
2
4
6
8
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4

12. Crisis and the Bubble Burst:

13. Crisis and the Bubble Burst:
Mishkin (2007) and Jonas and
Mishkin (2005) state that net
(core) inflation model is
frequently
– more volatile and
– it leads to targets being missed
more than would have been
case with the headline inflation.
See:
– Mishkin, F: Monetary Policy
Strategy, MIT Press, 2007
– Jonas and Mishkin (2005)
Inflation targeting in Transition
Economies, in Bernanke, B. and
Woodford, M. Inflation targeting
debate, NBER 2005-4
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0
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4
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4

14. Crisis and the Bubble Burst:
Quite few articles show how
contagion of sub-prime MBS
(mortgage based securities)
collapse spread beyond the
borders of US.
e.g.:
Steven B. Kamin and Laurie
Pounder DeMarco(2010): How Did
a Domestic Housing Slump Turn
into a Global Financial Crisis?;
Federal Reserve System
International Finance Discussion
Papers 2010.
Brender A and Pisani, F.(2010),
CEPS, Brussels.
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0
4
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1985 1990 1995 2000 2005 2010
R_FED_TGT PI100*4 PRIME_R
-4
-2
0
2
4
6
8
10
12
1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4

15. Why the Bubble Burst: Similarly to the 1929 Great
Depression crisis,
a sudden and sharp monetary
tightening
with target rate rising 6% in
period form 2004-2006
most likely triggered the 2007
bubble burst too.
See:
Bernanke, Ben S. (1983), Non-
Monetary Effects of the Financial
Crisis in the Propagation of the Great
Depression, American Economic
Review,73(3), June 1983, 257-76.
Bernanke, B. 1995: The
Macroeconomics of Great
Depression, Journal of Money, Credit
and Banking v.27, No. 1 (Feb. 1995)
1-28-4
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4
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1985 1990 1995 2000 2005 2010
R_FED_TGT PI100*4 PRIME_R

16. 10000
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70000
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90000
1985 1990 1995 2000 2005 2010
BNKRPC
Why the Bubble Burst: Debt accelerator
I.e., the 2007 bubble burst was
triggered by a combination of
interest rate increase and
an un-foreseen accelerating
effect of high debt:
the unusually high borrowing
caused by the low rates in the
previous period
had devastating effect on the
disposable income of the
borrowers once the rates
suddenly rose, and, caused
a drop of the consumption
demand and
the resulting drop in GDP
and bank bankruptcies-4
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0
2
4
6
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4

17. Why the Bubble Burst: Debt accelerator
E.g. a cash and a interest only
mortgage strapped household,
with mortgage 30% of
disposable income
after interest rates doubled,
could not continue repaying
mortgage which
now amounted to 60% - 90%
of their disposable income.
Nor it could spend as usually.
This dual accelerating effect
then lead to
– collapse of demand
– GDP, and
– bank bankruptcies, further
accelerated by many fixed-rate
mortgages
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4
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1985 1990 1995 2000 2005 2010
PC_PC

18. How the Bubble Burst accelerated:
than the known mechanisms of
– financial a(de)ccelerator and
– credit rationing
– animal (hurd) instinct
were also triggered fuelling the
crisis further and,
CDO & CDS contagion farther.
Bernanke, B, Gertler, M. and
Gildchrist, S. 1999: The Financial
Accelerator in a Quantitative
Business Cycle Framework, O J.
Taylor and M. Woodford, eds.
Handbook of Macroeconomics,
North Holland, Amsterdam, 2000.
Stiglitz J.E and Greenwald, B.:
Towards a New Paradigm in
Monetary Economics, CUP 2003
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1985 1990 1995 2000 2005 2010
rr_fed_tgt_pi=r_fed_tgt-pi100*4
PI100*4
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1985 1990 1995 2000 2005 2010
PC_PC

19. Possible rationale for keeping target rates low :
Keeping wolfs of Japan-like deflation outside gates
to encourage households’ consumption and growth
Fed unaware of looming inflation in 2003-4 due to
incomplete real-time data,
FED using starting to use core rather than the
headline inflation measure,
Model Insufficiencies
Distortionary political effect of Presidential elections
in 2004 and 2008

20. Model Insufficiencies
Bernanke, B, Gertler, M. and Gildchrist, S. 1999 as many
other authors use standard linarised Euler equation
• ct= -σrt + E(ct+1)
but it can not capture the time-variant effect of time
variable loans on σ or on E(ct+1) due to RE.
Also, most commonly used household budget constraint
equations such as Smets and Wouters
accounts for income but it does not account for the loan
borrowing effect.
See: Smets, F. and Wouters, .: Shocks and Frictions in US
Business Cycles: A Bayesian DSGE Approach, American
Ecnomic Revieew, 2007. (model in Appendix document)

21. Possible rationale for keeping target rates low :
Distortionary effect of Presidential elections in 2004 and 2008:
Alesina et al(1992) and find
“Our results can be summarized as follows: ….
2) We see some evidence of “political monetary cycles,” that is,
expansionary monetary policy in election years;
3) We also observe indications of “political budget cycles,” or
“loose” fiscal policy prior to elections;
4) Inflation exhibits a post-electoral jump, which could be
explained by either the pre-electoral “loose” monetary and fiscal
policies and/or by an opportunistic timing of increases in publicly
controlled prices, or indirect taxes.”
see: - Alesina, A. Cohen G. D., Roubini, N. Macroeconomic Policy and
Elections in OECD Democracies, Economics & Politics Volume 4, Issue
1, pages 130, March 1992
- Frenzese, R.J. : Electoral and Partisan Manipulation of Public Debt in
Developed Democracies, 1956-90, Institute for Social Research, The
University of Michigan working paper, May 1999

22. Conclusions: Keeping interest rates low
despite inflation and targeting
rule, and,
then rising them sharply
contributed to the housing market
bubble growing and
its bursting, respectively.
Consequently, some form of either
loan debt/GDP and/or
housing asset price bubble
targeting should be included in
the stricter followed Taylor rule, or,
additional FM control mechanism
in a richer, more complex, multiple
(heterogeneous) agent models so
that bubbles can be contained and
managed better.
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1985 1990 1995 2000 2005 2010
INV_REAL_EST_LNS_PERGDP
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100
50 55 60 65 70 75 80 85 90 95 00 05 10
PDEBT_PER_GDP_DFLT

23. Effects of inflation targeting misfiring on
development of housing market bubble
and its bursting in 2008 credit crisis
Author: George Perendia, LMBS
e-mail: george@perendia.orangehome.co.uk
Thank you for listening!