Kenneth Rogoff: The Fed v the Financiers

Ken Rogoff weighs in on how the Fed should respond to the subprime meltdown:

The Fed v the financiers, by  Kenneth Rogoff, Project Syndicate: In his ... address to the ... annual monetary policy conference in Jackson Hole..., US Federal Reserve chairman Ben Bernanke coolly explained why the Fed is determined to resist pressure to stabilise swooning equity and housing prices. Bernanke's principled position ... has set off a storm in markets, accustomed to the attentive pampering lavished on them by Bernanke's predecessor, Alan Greenspan.

This is certainly high-stakes poker, with huge sums hanging in the balance in the $170 trillion global financial market. ... But who is right, Bernanke or Greenspan? ...

A bit of intellectual history is helpful... As an academic, Bernanke argued that central banks should be wary of second-guessing massive global securities markets. They should ignore fluctuations in equity and housing prices, unless there is clear and compelling evidence of dangerous feedback into output and inflation. ...

But Greenspan's memoirs, to be published later this month, will no doubt strongly defend his famous decisions to bail out financial markets with sharp interest rate cuts in 1987, 1998 and 2001, arguing that the world might have fallen apart otherwise.

On the surface, Bernanke's view seems intellectually unassailable. ... Bernanke knows as well as anyone that none of the vast academic literature suggests a large role for asset prices in setting monetary policy, except in the face of extraordinary shocks ... such as the Great Depression of the 1930s. ...

But, while Bernanke's view is theoretically rigorous, reality is not. One problem is that ... central banks [may not] actually know what output and inflation are in real time. In fact, central banks typically only have very fuzzy measures. ... Even inflation can be very hard to measure precisely. ...

So, ... as computer programmers say, "garbage in, garbage out". Stock and housing prices may be volatile, but the data are much cleaner and timelier than anything available for output and inflation. This is why central bankers must think about the information embedded in asset prices.

In fact, this summer's asset price correction reinforced a view many of us already had that the US economy was slowing, led by sagging productivity and a deteriorating housing market. I foresee a series of interest rate cuts by the Fed, which should not be viewed as a concession to asset markets, but rather as recognition that the real economy needs help.

In a sense, a central bank's relationship with asset markets is like that of a man who claims he is going to the ballet to make himself happy, not to make his wife happy. But then he sheepishly adds that if his wife is not happy, he cannot be happy. Perhaps Bernanke will soon come to feel the same way, now that his honeymoon as Fed chairman is over.