The presentation investigates whether the Federal Reserve can possibly manage asset bubbles (real estate, stocks) in addition to managing its primary goals (inflation, sustainable growth).

1. Managing Bubbles The Scalextric Trap Guy Lion December 2008

7. The benchmarks Benchmarks highlighted in red denotes bubbles. The ones highlighted in green denote a variable is receding (opposite of bubble). As an example, yearly inflation is “bubbly” when the CPI has increased by more than 4.2% over past 4 quarters. Inflation is deemed low when it was less than 2%.

8. Correlation matrix Here is the quandary, Inflation and GDP growth are already negatively correlated (periods of stagflation, etc…) making monetary policy challenging. But, the assets (stocks and real estate) are quite strongly uncorrelated with inflation. And, have near zero correlation with GDP growth. If the Fed was to focus at all times on all 4 objectives, it would constantly hit contradicting policy situations with at least 2 of the 4 objectives.

9. Correlation – visual representation - the early Volcker years - This shows just the beginning of the reviewed period covering the early Volcker years. This table shows from left-to-right first the traditional Fed targets: yearly inflation and quarterly GDP growth; and next the asset price indicators: home price indicator (Home price/Family income), and stock price indicator (stock market cap/GDP). The red cells are the “bubbly” ones, the green ones are the receding ones as defined earlier. This short slice of history highlights the strong negative correlation between inflation levels (bubbly red) and stock levels (receding green).

10. Correlation - visual representation – - the whole period - Please note: First, when the assets (stocks, real estate) are bubbly (red), the Fed targets (inflation, GDP) are not (white or green) and vice versa. Second, since 1997 one asset or the other (stock, real estate) has been in a constant Bubble state meanwhile the Fed targets (inflation, GDP) behaved conservatively. You can see the data within the workbook Bubble model.xls Dot.com Stock market bubble Housing bubble Double digit inflation during Volcker years

11. Monetary Policy = Scalextric You may remember this game where you drove a single car with electric controls and raced against your friends. Now, the four cars represent the different macro variables. They are on totally different positions on the economic curve and need to be driven at different speed. Yet, the Central Banker has only a single set of controls to drive all four cars (variables)!

14. Playing Scalextric causes rapid aging

15. Job Ad for Bernanke’s successor The less the better. Whenever you open your mouth, the stock market could crash. And, it would be all your fault. Communication style Once the Fed is done with you, we guarantee career burn out. Career prospect Whatever went wrong will be your fault. Whatever did not was due to randomness. You’ll read it in Wikipedia. Legacy Solve problems before they emerge, otherwise you will be blamed for them. Responsibilities Your boss is the bond market. Expect communication challenges. No hand holding here. Hierarchy We grossly underpay to keep the hedge fund crowd away. Pay We offer no vacation. See “Lifestyle” above. Benefits Financial crises don’t sleep. You shouldn't either. Lifestyle Expect ambiguity. Whatever worked is history. Impact At any one time half the financial community will be really upset at you. They’ll give you plenty of feedback. Feedback