Alan Greenspan on Monetary Policy and bubbles

In a belated acknowledgement of the reality, Alan Greenspan has given his considered opinion on various monetary policy related issues in a WSJ article, The Roots of the Mortgage Crisis. After more than a quarter century of being at the helm of the Federal Reserve, he appears to have come to the following conclusions, all of which have important ramifications on policy making.

1. Monetary policy or other policy instruments are ineffective in deflating asset bubbles.
2. Long term interest rates have been decoupled from national or local economic forces (and to that extent Central banks) and are dependent on global economic trends. Asset prices are getting decoupled from short term interest rates.
3. Role of Central Banks will be increasingly limited to influencing short term interest rates

He is categorical in asserting that bubbles cannot be safely defused by monetary policy. He writes, "After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century."

In a belated but unambiguous acknowledgement of his role in ushering in long term distortions to the US economy, he writes, "I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major."

It is very difficult to judge the success or otherwise of monetary policy interventions. He says, "I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one."

He highlights the peculiar phenomenon of long term interest rates remaining stable and constant despite the 17 continuous quarters of monetary tightening by the Federal Reserve, as the definitive proof of the inefficacy of monetary policy, in deflating bubbles.

He writes, "In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates. Arbitragable assets--equities, bonds and real estate, and the financial assets engendered by their intermediation--now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge."