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Wednesday, October 26, 2005

Ben Bernanke: We Cannot Practice Safe Popping

Brad Delong is battling the false perception that Ben Bernanke is soft on inflation, a point made here as well, and Brad is right. If analysts continue to spread this myth about Bernanke gleaned from a misreading of a statement about how to prevent costly disinflation, the Fed will be forced to demonstrate its commitment to price stability, and forcing the Fed to increase interest rates to establish the appropriate credentials is not desirable.

What about another concern regarding monetary policy recently, asset bubbles? Will Bernanke change the Fed's current view that managing asset prices is outside of its purview? This statement from an American Economics Review Papers and Proceedings volume from 2001 should help to clarify Bernanke's position:

Should Central Banks Respond to Movements in Asset Prices?, by Ben S. Bernanke and Mark Gertler: ...The inflation-targeting approach gives a specific answer to the question of how central bankers should respond to asset prices: Changes in asset prices should affect monetary policy only to the extent that they affect the central bank’s forecast of inflation. ... In use now for about a decade, inflation targeting has generally performed well in practice. However, so far this approach has not often been stress-tested by large swings in asset prices. [Author web page versions here and here.]

The stress testing he mentions, an indication his view on is not yet etched in stone, is now being performed and his hand will soon be on a key lever in the process, interest rates. But this doesn't explain why the Fed shouldn't respond. For more on that, here's a 2002 Fed speech from Bernanke. Once again, we see that his mind is not entirely made up on this issue, but he is persuaded by arguments that bubbles cannot be reliably identified in time to prevent them, and even if they could, monetary policy is too blunt an instrument to use if the intent is to prick individual bubbles:

Asset-Price "Bubbles" and Monetary Policy, by Ben Bernanke: ... My talk today will address a contentious issue, summarized by the following pair of questions: Can the Federal Reserve ... reliably identify "bubbles" in the prices of some classes of assets, such as equities and real estate? And, if it can, what if anything should it do about them?  ... My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, Use the right tool for the job. ... The Fed ... has two broad sets of policy tools: It makes monetary policy, which today we think of primarily in terms of ... setting ... the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight, and a lender-of-last resort function ... The first part of the prescription implies that the Fed should use monetary policy to target the economy, not ... asset markets. ... [F]or the Fed to be an "arbiter of security speculation or values" is neither desirable nor feasible. ... The second part of my prescription is for the Fed to use its regulatory, supervisory, and lender-of-last-resort powers to protect and defend the financial system.

...[T]he framework just articulated is not universally accepted  ... And, in my opinion, the theoretical arguments that have been made for the lean-against-the-bubble strategy are not entirely without merit. ... If we could accurately and painlessly rid asset markets of bubbles, of course we would want to do so. But ... the Fed cannot reliably identify bubbles in asset prices. ... [and] even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them. ... As a matter of logic, the fact that bubbles are difficult to identify with precision does not necessarily justify ignoring potential ones ..: Even if we can measure bubbles only imprecisely, is the optimal response of monetary policy to a perceived bubble literally zero? Shouldn't there be at least a bit of response, for "insurance" purposes? ... [But] Is it plausible that an increase of ½ percentage point in short-term interest rates, unaccompanied by any significant slowdown in the broader economy, will induce speculators to think twice about their equity investments? ... Although neither I nor anyone else knows for sure, my suspicion is that bubbles can normally be arrested only by an increase in interest rates sharp enough to materially slow the whole economy. In short, we cannot practice "safe popping," at least not with the blunt tool of monetary policy. ... One might as well try to perform brain surgery with a sledgehammer. ...

A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed...

Things could change in the future under Bernanke as new ideas and new research on the Fed's role in managing asset price bubbles comes to light, but I don’t expect much, if any change in the Fed's hands-off policy regarding asset price management, and if there is change, it won't be immediate. One final note. I was struck in reading this speech how similar it is to very recent discussions emanating from FedSpeak on this issue, an indication of the influence Bernanke has within the Federal Reserve.

[Update: The Washington Post discusses this here.]

    Posted by on Wednesday, October 26, 2005 at 12:15 AM in Economics, Housing, Monetary Policy | Permalink  TrackBack (1)  Comments (12)


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