The logical error lies in confusing the purposes of an investor with those of a policy analyst. Suppose I work for the Fed, and my goal is not to amass a personal stash but to formulate economic policies that will promote prosperity for the country as a whole. In that case, it doesn’t much matter whether the bubble bursts in 2006, 2007 or 2010. In fact, the longer the bubble goes on, the more damage will result from its deflation. At the policy level, the relevant question is whether trained analysts, assembling data and drawing on centuries of experience in financial manias, can outperform, say, tarot cards in identifying bubbles. The EMH does not defend tarot.His point is that traders may be idiots, looking for the last drink at the bar, but the Fed should have better motives. Peter Dorman says the Fed could have acted better, faster sooner.
My claim is that the Fed was raising rates by 2004 3rd quarter, according to standard rules. The traders were too crowded to respond.
My argment is so: The Fed used is normal reliable raising of the rates, and the Fed assumed the markets were perfectly aware of the normal raising of the rates. The Fed performs the raisings at regular rate so the market has plenty of warning. The Fed was already up a point by 2005, the market should have been aware. The Fed was doing its job, with respect to housing.
The question was why didn't the market recognize the one point rise in 2005 and start to equalize the yield curve by then? The answer is the market had already crowded into all available yield opportunities by mid 2003, traders had no other game then to play . If the Fed wanted to act, it should have started its slow rate rise in mid 2003. But at that point, housing was well within recent range with no apparent bubble.
The problem was not housing, it was something else, as traders looking for yield had crowded all opportunities by 2003. Even with the Fed signal by 2005, there was no other bar open, so they played until closing. Given that a housing crash was eminent, I ask, what is the best available crash point? The market chose its optimum housing crash point, 2006. But take a look at the year after the 2006 housing bust, what were traders doing? They were out in the street, still drinking until mid 2007, even with an inverted yield curve.
The markets wanted to crash based on some other constraint not housing. The crash constraint they wanted was oil prices. If the Fed were to respond correctly the Fed would have watched oil prices, which were well constrained by 2003. Or better, the Fed should have started rates rising on the day lil Bush cut taxes!
If you want Ben to act correctly today, he should be raising rates and forcing Congress to come to terms with the budget.
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