The importance of expectations

I often argue that current NGDP depends heavily on future expected NGDP. That’s also a prediction of modern New Keynesian macro models. However, this generalization is less true during the current Covid pandemic, as current output is artificially depressed by social distancing.

But even social distancing cannot stop asset markets from looking ahead. The current price of assets such as houses is roughly equal to the 12-month future expected price (a bit lower due to trend inflation.)

Consider the recent boom in house prices, occurring despite a severe recession with 10 million fewer jobs than a year ago:

Home prices surged the most on the record in the third quarter, according to a report Tuesday from the Federal Housing Finance Agency.

With record-low mortgage rates fueling demand for housing, prices jumped 3.1% compared to the prior quarter. That was the biggest gain in records dating to 1991, according to FHFA.

Compared to 2019, prices were up 7.8% in the three months through September, the biggest jump since 2006.

What’s going on here?  I’d point to three factors:

1.  An expectation that the Covid pandemic will be over within 12 months, probably even sooner, due to the many vaccines being developed.

2.  A long run downward trend in interest rates that began in the early 1980s and shows no sign of ending.

3.  Increasingly strict land use rules, motivated by “NIMBY” attitudes among the public.

Because the first point is fairly obvious, let me focus on the other two.  We don’t know all the reasons why interest rates are trending lower, although demographics are probably one factor.  Population growth in slowing, and interest rates fell first in places like Japan, where population growth slowed earlier than in the US.

(I suspect that our economy’s shift in emphasis from building things to creating ideas also plays a role.)

But the second reason (lower interest rates) would not normally be enough, for “never reason from a price change” reasons. In a well functioning economy, higher housing prices should lead to more new construction.  Anticipation of these increases in production would limit the price increase.  That used to happen in the mid-20th century, when it was fairly easy to build houses in America.  In recent decades, however, it’s become harder and harder to build new homes, in more and more cities.  Thus we will increasingly resemble places like the UK, Hong Kong, Canada, Australia and New Zealand, where house prices have reached a permanently high plateau (in real terms) due to strict building limits.

There are also lessons for monetary policy.  Just as expectations of high post-pandemic house prices create high house prices today, expansionary monetary policy that boosts expected future NGDP can boost NGDP right now.  Indeed this is basically the argument for average inflation targeting–create future inflation expectations to raise current inflation.  Bullish expectations can’t work miracles (for output) when a real shock like Covid causes people to hunker down, but in a normal recession the expectations channels is by far the most important part of stabilization policy–Nick Rowe likes to say it’s about 99% of monetary policy.