Housing Bubbles: An Ounce of Prevention is Worth a Pound of Cure

Prescription for preventing housing bubbles from the IMF…

iMFdirect - The IMF Blog

By Kevin Fletcher and Peter Kunzel

The main features of boom-bust cycles in housing markets are by now all too familiar.

During booms, conditions such as lax lending standards and low interest rates help drive up house prices and with them mortgage debt.

When the bust arrives, over-indebted households find themselves underwater on their mortgages— owing more than their homes are worth.

Feeling the pinch of reduced wealth and access to credit, households, in turn, rein in consumption. At the same time, lower house prices cause investment in new houses to tumble.

Together, these forces significantly depress output and increase unemployment. Non-performing loans increase, and banks respond by tightening credit and lending standards, further depressing house prices and adding to the vicious cycle.

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The Persistence of Deflationist Psychology

Seven and a half years after the financial world as we know it almost completely blew up, deflation remains the biggest fear across the land. Some major central banks across the globe have had to double down on their efforts to fight deflation. For those like me who expected central bank activism to quickly lead to rampant inflation, this world of persistent deflationist psychology is a wonder to behold.

Along this vein comes a fascinating article in the New York Times called “A Prediction Market for Inflation, or Deflation” by Justin Wolfers, a a senior fellow at the Peterson Institute for International Economics and professor of economics and public policy at the University of Michigan. Wolfers warns that the Fed’s focus on hiking rates runs counter to declining expectations for inflation:

“Something unusual is happening to prices right now: They are falling.

The recent sharp decline in gas prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 percent inflation target, hindering the economic recovery. There’s also a small but worrying risk that the economy could enter a deflationary rut.”

Incredulous, I read on….

The majority opinion marginally expects the Fed to miss its 2% inflation target in the next 5 years

Opinion is skewed to a Fed miss of its 2% inflation target in the next 5 years

After seeing this chart, I feel that Wolfers far over-stated the case for a “deflationary rut.” This chart shows that 49% of the prediction market expects the Fed to deliver. That is a pretty good percentage although we of course would prefer higher. Wolfers focuses in on the skew of expectations; that is, the people who think the Fed will miss the mark on inflation are predominantly expecting an undershoot. Note that only 1% of the prediction market currently expects deflation in the next 5 years. I do NOT equate an expectation of missing the 2% the target as a deflationary risk.

The main lesson for those of expecting Fed policy to lead to excessive inflation is that we remain a distinct minority. Very few people are worrying about inflation in financial markets.

Wolfers provides this good caveat on interpreting prediction markets:

“Of course, the specific probabilities inferred from market prices should be taken with many grains of salt. In particular, traders may not be betting that prolonged deflation is probable, but rather be buying insurance against such a grim occurrence. Thus, prediction market prices might overstate the probability of bad outcomes. Nonetheless, these prices embed a powerful message for policy makers: Just as people buy flood insurance when they’re concerned that a storm might do terrible damage, traders might be buying deflation insurance because they fear the risk of vast economic damage if the economy were to enter a deflationary rut.”

And a nice message for those of us expecting problems with inflation in the near future:

“Next time people tell you that higher inflation is coming, remind them that they can get rich in the derivatives markets if they’re willing to put their money where their mouth is.”

In the end, seeing Wolfers turn relatively mild data into a warning on deflationary risks is yet one more example of how deflationist psychology persists in economic thinking despite years of accommodative Fed policy, lots of money printing, and more printing to come…

It's a wonder sometimes that gold has been able to hold on as high as it is...

It’s a wonder sometimes that gold has been able to hold on as high as it is…

Full disclosure: long GLD