This post is intended to offer a little theoretical basis on the folly of price fixing by the Fed, if it wanted to keep asset prices stable. What would happen if the Fed wanted to use monetary policy to keep houses selling at their bubble peak values?
I’m going to build a model that begins with extreme simplicity and then adds layers of complexity as we go. Say the only thing for sale is McMansions, and the Fed wants to keep them all fixed at a million bucks a pop. For now, in this simple example, the inventory of McMansions stays the same month-to-month.
The cost per McMansion is directly proportional to the money supply, and inversely proportional to the number of McMansions. Money supply is printed currency (P) + credit (C); divide that by inventory (I) to approximate the cost per unit ($).
So: $(McMansion) = (P+C)/I. A shrinkage of money supply puts a downward pressure on prices ($). Alternatively, if the desirability of McMansions falls and puts a downward pressure on prices (with money supply constant), then some go unsold, and inventory tends to increase. To price fix, the ratio of money supply to inventory has to be kept constant.
As credit grew over the past few years, McMansions rose from $500,000 to a million. If nobody is borrowing anymore, the money supply/inventory ratio must be kept constant—so cash (P) has to be printed to make up for diminishing credit (C). This keeps the money supply even, and therefore the ratio of money supply to inventory is fixed.
But some McMansions will be in better locations, or some will have more granite countertops than others, or big screen TVs, or whatever. There will be variances in prices. To keep them all fixed, we can still consider the ratio of money supply to the sum of the variably priced McMansions. Each McMansion in the inventory denominator can be weighted in terms of its bubble peak price divided by that of the average McMansion, and all of those weighted McMansions can be summed, and the ratio of money supply to inventory still holds for each given unit. If the Fed can replace lost credit—either through easier credit than before, or printing cash—it can fix variably priced McMansions similarly to ones that are all priced the same.
Say heating bills increase, and McMansions are seen as a silly purchase to begin with, their desirability drops. People just aren’t buying them like they used to. As the inventory denominator of the ratio grows, so must the numerator. Now, not only must the Fed replace lost credit with printed cash (or really easy credit), it must create more money to keep the numerator proportionate to the expanding inventory denominator. If the inventory doubles, you have to double the money supply to keep prices fixed.
Say McMansions are only half the economy, the other half is oil and wheat, whose prices are rising. Since money supply, at a given moment, is a finite number, what is given to oil and wheat is taken away from the McMansion budget. McMansion money supply shrinks. So to price fix, the Fed must compensate that shrinkage. Say oil and wheat rise so high they now consume 75% of spending, then only 25% of the general budget is left for McMansions. To price fix, the Fed has to double the money supply, and if people are tired of borrowing easy credit, or they’ve borrowed all they can pay back, that means printing.
Bottom line, if the Fed tries to fix prices, invest in oil and wheat.