Summers Rally

It is truly incredible that “this” is what pushes markets higher today.

The literature generally defines a bubble as a situation where the price of an asset—in this case, housing—is significantly higher than its fundamental value. One common way of judging whether housing’s price is in line with its fundamental value is to consider the ratio of housing prices to rents. This is analogous to the ratio of prices to dividends for stocks.

I want to emphasize, though, that this is a loose relationship that can be counted on only for rough guidance rather than a precise reading.

Higher than normal ratios do not necessarily prove that there’s a house-price bubble. House prices could be high for some good, fundamental reasons.

How, then, should monetary policy react to unusually high prices of houses—or of other assets, for that matter?

The debate lies in determining when, if ever, policy should be focused on deflating the asset price bubble itself.

In my view, it makes sense to organize one’s thinking around three consecutive questions—three hurdles to jump before pulling the monetary policy trigger. First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?

My answers to these questions in the shortest possible form are, “no,” “no,” and “no.”

By Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco, October 21, 2005