Editor's Pick: Fed did NOT feed the housing bubble

Mikka Pineda | Nov 07, 2007

Contrary to popular belief, Robert J. Shiller (of Irrational Exuberance) argues low interest rates were not responsible for high asset prices. Excerpts from his recent paper "Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Models":

Long rates are not any lower now than they were in the 1950s, but the high rates of the middle part of the period are gone now. In the US, long rates are actually above the historical average 1871-2007, which is 4.72%. The best one could say from this very long-term historical perspective is that US long rates are not especially high now.

The long-term average ex-post real U.S. long-term government bond yield 1871-1997 is 2.40%, lower than was seen in 1997 (the last year we can compute this yield without making assumptions about the future). Even today, using the latest inflation rate as a forecast, US real long-term interest rates are not obviously low compared to this long run average.

A remarkable boom in home prices has appeared since the peak in long rates in the early 1980s. However, the uptrend in home prices clearly does not begin until the late 1990s, after most of the downtrend in nominal interest rates had passed. It seems that, although it might seem at first that there is a substantial negative correlation historically between asset prices and interest rates, this correlation is actually very weak.

One would expect that a sharp increase in real interest rates at long maturities, caused by fiscal and monetary policies, would depress stock prices significantly. Yet in all major countries, real stock prices have been surprisingly strong. Dividend-price ratios have in no way followed real rates on long-term bonds.

A perception that there is such a relationship [between nominal interest rates and asset prices] may have an influence on the market; it may help frame today's market as justifiably high...The concept of real interest rate remains totally absent from the popular model of the economy...The money-illusion theory that low nominal interest rates help propel real long term asset prices upwards in a time of declining inflation may seem a little unsatisfactory since it describes people as understanding enough about inflation so as to push nominal rates down in declining-inflation periods but not understanding it well enough that they should realize that these lower nominal rates should not be used to discount today's dividend into a higher price.

Of course, if the pricing of financial assets were exclusively the domain of a small group of sophisticated investors, the so-called "marginal investors," then it would not matter that the general public was making mistakes. However...there are reasons to think "smart money" cannot rectify long-term mispricings of major asset classes.

Long-term interest rates have not been especially low. What has changed to produce high asset prices appears instead to be changes in popular economic models that people actually rely on when valuing assets.