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Thursday, March 16, 2006

Monetary Policy and Asset Prices

Donald Kohn gave a speech on asset prices and monetary policy as part of a conference in honor of the ECB's chief economist, Otmar Issing who is retiring soon. The speech discusses a disagreement between Kohn and Issing on the role of central banks in managing asset prices:

Monetary policy and asset prices, by Donald Kohn, Fed Reserve Governor: I am honored to participate in this tribute to Otmar Issing. ... I can think of no better way to celebrate the signal contributions of this leading force in the world of monetary policymaking than to address an issue of great importance to central banks, ... the proper role of asset prices in the determination of monetary policy. Otmar and I have debated this issue on many occasions...

Two Strategies for Dealing with Market Bubbles Most fluctuations in stock prices, real estate values, and other asset prices pose no particular challenge to central banks... But many argue that pronounced booms and busts in asset markets are another matter, especially if actual valuations appear to be misaligned with fundamentals. What should a central bank do when it suspects it faces a major speculative event...? To help frame the discussion, I will focus on two different strategies that have been proposed for dealing with market bubbles.

The first approach--which I will label the conventional strategy--calls for central banks to focus exclusively on the stability of prices and economic activity over the next several years. Under this policy, a central bank responds to ... asset prices only insofar as they have implications for future output and inflation over the medium term. ...

The second strategy, by comparison, is more activist and attempts to damp speculative activity directly. ... I am labeling this second approach extra action, as it calls for steps that would not be taken in ordinary circumstances. Compared with the first approach, the extra-action strategy responds to a perceived speculative boom with tighter monetary policy--and thus lower output and inflation in the near term--with the expectation of significantly mitigating the potential fallout from a possible future bursting of the bubble. Thus, the strategy seeks to trade off the near-certainty of worse macroeconomic performance today for the chance of disproportionally better performance in the future... But the extra-action proposal is by no means a bold call for central banks to prick market bubbles. ... Rather, the extra-action strategy is intended only to provide some limited insurance against the possibility of highly adverse events occurring down the road.

Common Ground I will be talking at length about the differences between the two strategies, but I must stress up front how much they have in common. ... I think it fair to say that most central banks, faced with only a limited understanding of asset prices and their interactions with the full economy, engage in a form of risk management when dealing with market booms and busts. In part, they do this because any particular policy ... is never associated with a single forecast for the future paths of output and inflation but, instead, with a large set of possible scenarios with differing odds... While no one uses formal Bayesian methods to solve this difficult problem, I think most policymakers do engage in at least an informal weighing of the various possibilities and their implications when setting policy.

Three Conditions for Extra Action to Lead to Better Outcomes Now let me turn from areas of agreement to more contentious issues... As I see it, extra action pays only if three tough conditions are met. First, policymakers must be able to identify bubbles in a timely fashion with reasonable confidence. Second, there must be a fairly high probability that a modestly tighter policy will help... And finally, the expected improvement in future economic performance that would result from a less expansive bubble must be sizable. ...

To wrap up this critique, I summarize as follows: If we can identify bubbles quickly and accurately, are reasonably confident that tighter policy would materially check their expansion, and believe that severe market corrections have significant non-linear adverse effects on the economy, then extra action may well be merited. But if even one of these tough conditions is not met, then extra action would be more likely to lead to worse macroeconomic performance over time than that achievable with conventional policies that deal expeditiously with the effects of the unwinding of the bubbles when they occur. For my part, I am dubious that any central banker knows enough about the economy to overcome these hurdles. However, I would not want to rule out the possibility that in some circumstances, or perhaps at some point in the future when our understanding of asset markets and the economy has increased, such a course of action would be appropriate.

Asymmetries and Moral Hazard Proponents of extra action have their own bones to pick with the conventional strategy... In particular, the claim is often made that, based on the FOMC's actions over the past twenty years, the Fed actively works to support the economy in an event of a sharp decline in asset markets but does little or nothing to restrain markets when prices are rising, thereby creating moral hazard problems.

This argument strikes me as a misreading of history. U.S. monetary policy has responded symmetrically to the implications of asset-price movements for actual and projected developments in output and inflation, consistent with its mandate. ... Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk. Whatever might have once been thought about the existence of a "Greenspan put," stock market investors could not have endured the experience of the last five years in the United States and concluded that they were hedged on the downside... Nor, for that matter, should they have concluded that the Federal Reserve does not act on the upside... one can argue that extra action may pose a more significant risk of moral hazard. ...

One more thought. If the central bank is perceived to be actively managing asset prices and the economy crashes, its reputation could take a substantial hit. Of course the reverse is true too and it is the source of criticism of the Fed's actions surrounding the dot com crash, i.e. failure to act when a bursting bubble can be avoided is also a policy mistake. But given existing uncertainties, e.g. we don't know for sure if central bank policy could have changed the dot com outcome, it is easier to defend against the failure to prevent a crash than to justify actions that might have caused it.

    Posted by on Thursday, March 16, 2006 at 10:27 AM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (10)

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