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Thursday, January 12, 2006

New York Fed's Geithner on the Fed's Response to Asset Price Movements

New York Fed president Geithner discusses the development of global asset markets and the impact of the development on monetary policy. The speech begins with a review of the past year which echoes many previous reviews from the Fed, so I will skip forward to his remarks on how asset prices should affect monetary policy. He believes that asset price movements must be considered in setting policy, but only if changes in asset prices affect forecasts of inflation and output. Asset prices should not be the goal of policy. He also explains why negative asset price movements should command more attention from policy makers than positive movements.

Bottom line: We don't know as much as we'd like about how asset prices are determined or how changes in asset values affect inflation and output, but these markets are increasing in importance so we need to learn more. In cases where we are confident we understand how an event in asset markets will affect forecasts of inflation and output, policy should respond:

Some Perspectives on U.S. Monetary Policy, by Timothy F. Geithner, New York Fed Chair: ... There is a well established, and I believe fundamentally correct, case against directing monetary policy at specific objectives for asset values or the future path of those values. ... [A]sset values should be neither a target nor a goal of monetary policy. ... Because we know so little about how to assess the appropriateness of asset values against fundamentals, ... [m]onetary policy does not today and is unlikely in the future to offer us an effective tool for directly reducing the incidence of large or sustained deviations of asset values from ... their fundamental values...

That said, monetary policy still has to take into account the impact of significant movements in asset values on output and inflation. ... History provides us with numerous examples in which significant movements in asset prices have had sizable effects on the path of output relative to potential and on price stability. And experience suggests that asset values can be very sensitive to ... perceptions of future policy moves. The challenge for central banks is to determine how movements in asset values and expected asset values affect the evolution of the economy. ...

The incorporation of asset price movements into monetary policy formation is hard to do, in part, because we don’t know that much about the transmission mechanism from movements in asset values to the underlying economic fundamentals we care about. ... And successfully integrating asset prices into monetary policy formulation is also hard to do because of the difficulty of assessing how ... monetary policy will ... affect asset values. ... But to acknowledge these complexities does not weaken the case for ... trying to make sensible judgments about how monetary policy should respond to asset price developments. Here are some considerations:

First, in circumstances where the central bank observes a large realized movement in asset prices and is confident in its knowledge of the impact ... on ... aggregate demand, monetary policy may need to follow a different path than might have seemed appropriate in the absence of those developments. .... Of course central banks must always be prepared to respond when factors threaten to push aggregate demand away from aggregate supply and impact the inflation outlook. Movements in asset prices certainly have the potential to be one of those factors...

Because some asset prices may fall more abruptly than they rise, and because the effects of downward moves in asset prices on demand may be larger due to the greater negative impact of deflation on the net worth of borrowers—witness the United States in the 1930s or Japan in the 1990s, the case for adjusting monetary policy in response to negative asset price shocks is commonly considered more compelling than in the alternative context. ...

More generally, despite the fact that policymakers can’t be completely confident in their assessment of the future path of asset prices, it seems unavoidable that these assessments will factor into policy decisions. ... [P]olicy, in some circumstances, will need to respond to asset price movements when those movements alter the central bank’s assessment of the risks to its outlook...

This leaves us with no simple or clear doctrine for the role of asset prices in monetary policy regimes. Asset prices probably matter more than they once did, but what that means for monetary policy necessarily depends on the circumstances. ...

Update: See Nouriel Roubini's extensive comments on the significance of these remarks.

    Posted by on Thursday, January 12, 2006 at 12:07 AM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (7)

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