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Thursday, January 01, 2009

Pegging a Stock Price Index

More on targeting asset prices from Nick Rowe:

"The Bank of Canada should peg the TSE 300" - revisited, by Nick Rowe: "The Bank of Canada should peg the TSE-300" is the title of a Carleton Economics Department working paper I wrote in 1992. ... Given the recent turmoil in financial markets, and the renewed interest in having central banks look at asset prices, I was wondering whether to resurrect this paper, but dithered. Now Roger Farmer has beaten me to it. Mark Thoma posted it on his blog, and Tyler Cowen on his.

The reactions in the comments are mostly either unfavourable, or incredulous. I thought I would write a few words in defence of the idea, and then say why I no longer support it.

Many critics are just confused, and think that using monetary policy to peg an index of stock prices is some sort of interventionist policy that prevents markets finding their own equilibrium. But if governments produce money, and they do, then governments have to decide how much money to produce. They have to target something. That something can be the price of gold, or silver, or the exchange rate with another government's money, or the CPI (as in inflation targeting). Or it can be an index of stock prices. In principle, any nominal (measured in dollars) variable can be the target for monetary policy, and the TSX 300 is a nominal variable.

Pegging the TSX 300 is no more interventionist than pegging the price of gold, or pegging the CPI (as we do now with inflation targeting). In the long run, market forces determine the real (inflation-adjusted) value of the TSX 300 even if the Bank of Canada pegs the nominal value; the same is true if the Bank of Canada pegs the price of gold. ...

Let me be more precise. My 1992 proposal was that the Bank of Canada should peg the time-path of the total return index of the TSX 300, so it would grow at some fixed rate of (say) 7% per year. ...

There is one very curious effect of pegging the total return index to grow at (say) 7% per year. It would mean that a stock index fund would be as safe an investment as Canada Savings Bonds are now... It would be hard to imagine that the equity premium could persist, which could be an important advantage of the policy. All nominal interest rates on government bonds and other safe assets would have to pay the same 7% per year. ...

The main rationale for the policy would be the hope that it would tame financial bubbles and crises. Also, if stock prices predict the business cycle, and if this correlation implies causation, taming stock prices might also tame the business cycle.

It seemed to me a good idea in 1992, but this was before inflation targeting really got off the ground, so I didn't have much to compare it to. A few years ago, when inflation targeting seemed to be performing very well, I changed my mind, and decided it was "very interesting....but stupid". Now I am just uncertain. Here are the main problems.

First, stock prices are very flexible, but a lot of goods prices are very sticky. There is a long-standing principle in macroeconomics that business cycles are caused by sticky prices, and the best macroeconomic policy is to make sure that the prices which don't change quickly don't have to change quickly. This principle suggests we should target an index of sticky prices (or wages), and the CPI comes a lot closer to this than the TSX 300.

Second, the real fundamental equilibrium value of the TSX 300 can change by a large amount very quickly, due to fundamental changes in profitability, the growth rate of profits, or real discount rates. But if the nominal value of the TSX 300 were pegged, the only way the real value of the TSX 300 could reach its new equilibrium would be for the CPI to adjust. Big fluctuations in the CPI would be undesirable if they did occur, and even more undesirable if they needed to occur but couldn't, because goods prices are sticky. ...

Finally, the stock market is perhaps a barometer of the state of the economy, but we cannot be sure that pegging the barometer would stabilise the weather. Goodhart's law suggests the opposite. Perhaps the bubbles in asset prices that were suppressed would only pop up somewhere else. Indeed, the classical dichotomy suggests that they would pop up somewhere else; positive asset price bubbles would pop us as negative CPI bubbles.

I'm not prepared to rule out targeting some weighted average of goods prices and asset prices. But even a broad index of stock prices is a narrow representation of even financial assets, let alone land, houses, and human capital.

My proposal along these lines (which I am not firmly attached to, just thinking about the implications) is to add a stock price index, s, to the the standard Taylor rule involving output, y, and inflation, p. Thus, the federal funds rate would be set according to ff* = a + b(y-y*) + c(p-p*) + d(s-s*), where * indicates the target value, and then conventional open market operations would be used to hit the federal funds rate target. Thus, whenever stock prices begin drifting above the targeted rate of growth, the Fed would begin to tighten monetary policy using conventional means (ideally, the index s is broad based and constructed with optimal weights rather than being a narrow, value-weighted index like the S&P 500, update: also, the notation is sloppy, but I mean the rate of change in s, "the targeted rate of growth," not the level). The proposal from Roger Farmer, however, is a bit different than this in that it has the Fed controlling the index directly through the "buying and selling blocks of shares on the open market," something I didn't highlight enough in the discussion linked above. With the augmented Taylor rule approach, there is no need to buy and sell stocks, something I think is an advantage. But there can be advantages to direct control as well, e.g. there would be more variation in s under the Taylor rule approach than there would be if s were stabilized directly through buying and selling blocks of shares, so if stabilization of s is an important policy goal, direct control may be preferred.

    Posted by on Thursday, January 1, 2009 at 02:52 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (39)

          

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