Equity Extraction and Personal Consumption Expenditures

In comments to my previous post I made this statement of historical fact: "home price bubble equity was an ATM that grew consistently as a fraction of PCE after 1996, and accounted for over 2% in 2005 – and I got this from Greenspan and Kennedy, Table 2." In my estimation, this implies that the collapse of the housing bubble eliminated the possibility of equity extractions, and was therefore a major contributor to the decline in personal consumption expenditures [PCE] that led into the Great Recession.

Here is the explanation.

Bill McBride at Calculated Risk has been following the equity extraction data. Here is the March, 2014 update. Dr. James Kennedy, mentioned above, wrote that for technical reasons, the data set that he and Greenspan were using was no longer valid after 2008, and presented an alternate calculation method [link at the linked CR post.] McBride uses this alternate measure, calculated from the Fed's Flow of Funds data and the BEA supplement data on single family structure investment. Also linked at the CR article is a spread sheet with the two data sets. Graph 1, from CR, shows how the two data set compare.

Graph 1 - Equity Extractions - G-K Data vs CR Calculation.

I'm looking at the correlation between equity extractions and personal consumption expenditures during the housing bubble and collapse to support my claim. The method is to compare McBride's calculated data, which extends past the end of '08, and FRED Series PCE. Graph 2 shows Equity Extractions [blue, left scale] and the YoY dollar change in PCE [green, right scale] from 1991 through Q1, 2010, both in billions, quarterly data.

Graph 2 - Equity Extractions and PCE Change

The traces start rising together after the 1991 recession. There's a disconnect during the 2001 recession, when PCE takes a dive, but extractions continue to increase. From 2003 until the crash, they are close to being in lock-step; but from the peak, extractions fall farther and faster leading into the recession. One objection to my claim is that extractions decline a year earlier than PCE. We'll get to that.

Graph 3 shows a scatter plot of Year-over-year PCE dollar change vs equity extractions from Q1 2001 through Q3 2008

Graph 3 - PCE Dollar Change vs Equity Extractions - '01 to '08

The period from Q1, '01 through Q2, '03 is highlighted in red. During this time, PCE falls and levels off without a correlation to extractions. After mid '03, extractions and PCE rise together into the peak values highlighted in yellow, then fall together into the crash. R^2 for Q3 '03 through Q3 '08 is .75. This includes the blue and yellow points.

Graph 4 is a scatter plot of the Q1 '91 through Q1 '10 period. I've color coded data subsets representing different coherent realms.

Graph 4 - PCE Dollar Change vs Equity Extractions - '91 to '10

Starting from the 1991 recession in red, PCE increased into the cluster of purple dots representing Q1 '92 to Q1 '98. From Q2 '98 until Q1 '01 is another [less tight] cluster representing a greater change in PCE but only slightly higher equity extractions. This is the peak of the dot com bubble. Q2 '01 to Q2 '03 is again in red, the slide into and climb out of that recession. The blue dots, as in Graph 3, represent the period from Q3 '03 to Q3 '08 - the housing bubble peak and decline into the crash. The green dots are from Q3 '08 through Q1 '10, when everything collapsed and the correlation fell apart. The R^2 for all the data points except the green is .49. Eliminate the red dots as well, and it rises to .70. Take out the top 4 yellow dots, Q4 '99 to Q3 '00, and it rises further to .81.

This suggests that outside of recessions and the peak of the dot com bubble, which can be considered as distortions to a underlying trend, from 1992 on, changes in consumption expenditures were strongly correlated to mortgage equity extractions.

I used an ATM analogy for equity extraction, but there's a big difference. You can go to the ATM as often as you like, but extracting equity is an event that is unlikely to be repeated very often. So it's not out of the question to expect that the flow of equity dollars into consumption expenditures would be spread over several months - possibly a year or more.

I also looked at the correlation between extractions and the PCE dollar change 4 quarters later. This is shown in Graph 5.

Graph 5 - PCE Dollar Change vs Equity Extractions - '91 to '10

Color coordination, based on the PCE values, is the same as in Graph 4. The blue dots now make a more spiky array, but there is almost no loss in the coherence of the data sub sets. Only the green dots, now extended though Q1 '11, look substantially different.  R^2 for the blue dots slips from .75 to .56, but for the entire data set [except the green dots] it increases slightly from .49 to .55.

Extraction data is seasonal, with local peaks in Q's 2 or 3, and valleys in Q's 4 or 1.  This accounts for some of the data scatter.  PCE dollar change data is smoother, with no consistent seasonal pattern.  Graph 6 shows a scatter of 4Q averages of each variable, same color coding as graphs 4 and 5.  Not including the recession-related red and green dots, R^2 is .75.  Include the red dots and R^2 drops to .588.

Graph 6 - PCE Dollar Change vs Equity Extractions - '91 to '10 - 4 Q Avgs

It's now very easy to see the two variables rise and fall together from the time after the 2001 recession into the Great Recession.

I know correlation is not causation, but I have a coherent narrative that is completely consistent with the data. The behavior of the [blue dot] data from 2003 until deep into the collapse is striking, either with or without a 4 Q lag. Non-conforming data [other color dots] are explainable variances. I think the counter assertion that equity extractions had not a darned thing to do with the collapse into the great recession is not supported by real world data.

Did the Fed Cause the Great Recession?

With the release of the Fed's Open Market Committee Meeting minutes from 2008, it has been confirmed that the Fed was too concerned about inflation, and, to quote Marcus Nunes, "worse, the headline kind" leading into the 2008 crash.  The Market Monatarists cite this as evidence that the Fed was responsible for turning a potentially pedestrian downturn into the Great Recession.  See David Beckworth here. 

I'm not here to defend the Fed, but there are two issues. The first issue is their behavior - and if they mistook 2008 for 1978, that is inexcusable.

 And, as Marcus points out, it looks like they did. [Emphasis his]

Two speeches by voting Regional Fed presidents certainly helped perceptions along:

Plosner (July 22): Keeping policy too accommodative for too long worsens our inflation problem. Inflation is already too high and inconsistent with our goal of — and responsibility to ensure — price stability. We will need to reverse course — the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned around.

Hoenig (July 16): “While the comparison to the ´70s can be useful(!), the present economic situation is also different…

However, like the 1970s, monetary policy is currently accommodative(!)…In this environment there is a significant risk that inflation and inflation expectations could move higher in coming months.

Thus, it will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion”.

By their words shall you know them.  But only if you're paying attention.

Let's look more closely at that first issue - Fed behavior.  What was happening with inflation, and how did the Fed react?  Graph 1 shows headline inflation in blue and core inflation in red.

Graph 1 - Headline and Core Inflation

In mid 2008, core inflation was running at 2.3 to 2.5%, not far off its decade-long average of 2.2%, and had been pretty stable year to date.  Headline inflation, however, had taken a big jump.  As Graph 2 shows, headline inflation, now in red, was following the producer price index, in blue, which had taken an even bigger jump.

Graph 2 - PPI and Headline Inflation

As these graphs show, core inflation - which is what, if anything, policy makers ought to be reacting to - is much less volatile, and did not look at all like cause for concern.  But, as Steve Roth pointed out a while back, fighting inflation is the only part of its alleged dual mandate that the Fed takes seriously.  The scorpion has to follow its nature.

 Meanwhile, what was the economy doing back in 2008?

As Graph 3 shows, the growth in personal consumption expenditures had been in steady decline from the local high of just over 7% in 2005, was more or less stable through the first half of 2008 at about 4%, but then fell off to 1% in October.   It was deeply negative by the end of the year.

Graph 3 - Personal Consumption Expenditures

Not surprisingly, NGDP growth followed a similar path.  See Graph 4

Graph 4 - NGDP Growth

Meanwhile, Real Median Household Income, which had risen modestly from 2005-7, was slumping, probably due to income lost in the housing construction bust.  See Graph 5.

Graph 5 - Real Median Income Household

So, I think it's right and proper to criticize the Fed for their focus on inflation.  With 20/20 hindsight, it looks spectacularly wrong-headed.

The second issue is cause and effect between Fed action and the condition of the economy. Did the Fed really spawn the Great Recession in 2008?  David Beckworth says yes, and I believe the Market Monitarist community is unanimous on this point.  But let's look at what the Fed actually did.  Graph 6 shows the Effective Federal Funds Rate in blue.  Also included for reference is the Prime Lending Rate, in red, which follows in lock-step.

Graph 6 - Fed Funds and Prime Rates

The Fed Funds rate was shaved a bit from about 5.25% in the 3rd quarter of 2007, then cut dramatically to 2% by the end of the first quarter of '08.  In statements from the Open Market Meetings of August 5 and September 16, the FF target rate was kept at 2%.  Clearly, that decision did not hold, as the rate was hovering near 0% by the end of the year.

I hope I'm not misstating the Market Monetarists' stance when I say that they believe the Fed has essentially unlimited power to achieve whatever targets it chooses, and that in managing expectations, Fed words speak louder than actions. In a comment at Beckworth's post, linked above, I asked the following:

Regardless of what the Fed did or didn't say; during the first quarter of 2008, The Fed funds rate was cut in half from 4% to 2%, and between August and December dropped to almost zero.

Why do words [or the absence of words] trump what is actually happening in the real world? What percentage of the population has even the slightest awareness of the FOMC? Why would their announcements influence behaviors in the general population?

On October 8, they announced a 50 basis point cut to 1.5%, then to 1.25% on 10/29, on 12/16 the target was reduced to 0 to 1/4%.

When you consider that until the Fall of '07, the Fed Funds rate was over 5%, they did rather a lot taking it to essentially 0 in about 14 months.

What am I missing?

Part of his answer [read it all here, reposted as a follow-up here] was -

As I noted in the post, the key is to change the expected path of monetary policy. That means more than changing the federal funds rate. It means committing to keeping it low for considerable time like the Fed did in 2003 and signalling it clearly and loudly. With this policy, the Fed would have provided a check against the market pessimism that developed during this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten. So, yes, the correct response is far more than just cutting the federal funds rate, it is about setting expectations about the future path of policy and the future economic outlook.

I have a hard time accepting this ignore what I do, pay attention to what I say [or don't say] argument.  It has to assume that people are deciding their actions by thinking months or years into the future based on what they think the Fed might do then, instead of reacting to what is happening today.  Maybe I'm just disoriented by the time travel, but in a world where the major focus is on the current quarter's returns, I don't think very many actual people behave that way.  Nor do I believe that the hoi polloi have even the vaguest awareness of Fed activities, let alone their words.

The Market Monetarist response, from Marcus is, "Interest rates are a terrible (even misleading) indicator of the stance of monetary policy."  At his article linked in the first paragraph of this post, Marcus indicates that the true stance of monetary policy is the resulting growth in NGDP - which I believe, as post-hoc as it may be, is the axiom on which Market Monitarism rests. 

But there are other reasons to disagree.  Krugman provides two.  First, "We were in the midst of an epic housing bust, which was in turn causing a collapse in the value of mortgage-backed securities, which in turn was causing a collapse of confidence in financial firms."  This strikes me as being a market failure, aided and abetted [if not actually caused] by weak lending standards and lax regulation, and thus totally outside the realm of anything that can be effected by either setting or talking about interest rates, especially after the fact.

Second, "what we actually know is that the panic was in fact fairly short-lived, ending in the spring of 2009.  .  .  .  Yet the economy didn’t come roaring back, and in fact still hasn’t. Why? Because the housing bust and the overhang of household debt are huge drags on demand, even if there isn’t a panic in the financial market."  Again, it doesn't seem likely that Fed action or words would have any effect on this outcome.

Further, as Stephen Williamson puts it, "So, it's like there was a fire at City Hall, and five years later a reporter for the local rag is complaining that the floor wasn't swept while the fire was in progress."  A bit on the snarky side, but he also points out that the Fed had lost control of the Fed Funds rate at this time, anyway, due in part to risk perceptions.  This is shown in Graph 7.   What does this tell us about expectations at a time of panic?

Graph 7 - Federal Funds Rate, August - October '08.

He also indicated that the Fed loaned substantial amounts to financial institutions, starting early in '08, and increasing dramatically in September and October.  This is shown in Graph 8.

Graph 8 - Total Borrowings From the Fed

There was a lot of overt Fed action in 2008.  Maybe it was a bit sluggish, but if so, it was only lagging real world events by a few weeks.  They might have acted a bit quicker, but I don't see any more they could have done, other than talking differently.

Can those words really have been the cause of the greatest financial disaster in 80 years?

Afterthought:  It's entirely possible that the Fed, and most particularly bubble denier Alan Greenspan, were complicit in the many-years-long prelude that set the stage for the crash.  But that was much earlier and really is a separate set of issues.