On the Fed's demand bubble.

• Author: Niskanen, William A.

It should now be clear that the Federal Reserve caused, or at least accommodated, the bubble in aggregate nominal demand from early 1998 through early 2000. Moreover, the Federal Reserve chose to wring out this excess demand by late 2001, and by late 2002 total demand was significantly below trend (Figure 1). The primary open questions are whether the Federal Reserve should have caused or accommodated the bubble and what the Fed should have done once the bubble was in place.

At this point, it is important to distinguish between the bubble in aggregate nominal demand and the nearly synchronous and much larger bubble in equity prices. At the peak of the demand bubble, aggregate nominal demand was only about $320 billion above trend. The bubble in equity prices, in contrast, was about $7 trillion. The monetary stimulus that led to the demand bubble may have contributed to financing the equity bubble but was only a small part of that story. Another study would be necessary to estimate the magnitude and timing of the equity bubble if the Federal Reserve had maintained a trend rate of growth of aggregate demand throughout this period. Until such a study is completed, there is no basis for holding the Federal Reserve responsible for the equity bubble.

Stable Growth in Demand, 1992-98

I define a demand bubble as a level of demand that is significantly higher than expected. For this analysis, I define aggregate nominal demand as nominal final sales to domestic purchasers--an aggregate equal to nominal GDP minus the change in inventories minus exports plus imports. And I estimate expected demand based on the trend of this variable over some period before the bubble.

For the 25 quarters beginning with the first quarter of 1992 through the first quarter of 1998, this measure of demand increased at a remarkably steady 5.5 percent annual rate, as indicated by the following regression:

LD = 3.653 + .0551*YEAR + u, where LD is the log of demand. (.031) (.0003)

[R.sup.2] = .999 S.E.R. = .0029

The standard deviation of demand from this trend was less than 0.3 of one percent, and demand was always less than 0.7 of one percent from this trend. The Federal Reserve proved remarkably effective in stabilizing the path of demand over a period that included the jobless recovery of 1992, the preemptive attack on inflation in 1994, the Mexican financial crisis in 1995, the Asian financial crisis of 1997, and two presidential elections--despite the fact that it never...