A beautiful article on the life of Paul Krugman (HT: Stephen Kirchner). Well worth a read. Not sure what Stephen is talking about though. There is no ‘tragedy’ here.
And then there is this outstanding symposium of leading international central bankers and economists who were brought together to consider whether monetary policy should more explicitly account for asset prices, as Governor Stevens has argued of late (again care of Stephen).
Phil Lowe and Glenn Stevens like to tell us that there is a growing consensus (or ‘weight of opinion’) that central banks should be allowed to lean against asset prices. But how does this gel with the current views of Board Members of the European Central Bank, or the Governor of the central bank of Chile, as stated in their own words below (you could add others, like the Federal Reserve to that list as well)?
For the record, I am not against jaw-boning, although I think the policymaker needs to exercise exceptional care when doing so (we are all subject to human error and open mouth operations in the wrong direction can do more harm than good). I also think that, in extremis, there might be a case for subtle ‘signaling’ via the monetary policy instrument that the central bank is concerned about a credit-fuelled asset price boom, as is said to have occurred during 2002-03. And I like the way that Glenn Stevens describes that case study: the cash rate was going to change any way due to the RBA’s inflation-targeting requirements, but at the margin they sped up the rate of change by a few months. This represents a softening of my views, and is, to be sure, due to the persuasive powers of the RBA executive.
Yet as I argued yesterday, let’s not confuse personal opinion with what is and is not included in the ‘implicit contract’ that delegates the RBA its powers. For mine, this harks a little bit of John Hewson. Throughout the 1980s and early 1990s Hewson was arguing forcefully in favour of everything the RBA ultimately came to embrace: full independence; elimination of political interference from the interest rate setting process (and Prime Minister Paul Keating was still getting the RBA to change its decisions as late as 1994); a formal inflation target (albeit one lower than the RBA ended up opting for), and so on. Yet somehow Hewson and the RBA found themselves at loggerheads with one another. I am not sure who is to blame. But it is worth thinking about.
A standard risk-management perspective on this matter would conclude: why run the gauntlet of stretching the boundaries of your agreed responsibilities, and suffering the highly adverse consequences in the event that things go sour (eg, an attempt one day to influence asset prices back-fires on the RBA, which is a very real possibility), when you can transparently agree the changes to your mandate with the government of the day? In that way, you make them party to the decision, and prudently disperse responsibility. Which is exactly what the RBA leadership should be seeking to achieve: ie, to ensure that the RBA is always beyond governance reproach.
In any event, here are some alternative views on asset prices.
LORENZO BINI SMAGHI
Member of the Executive Board, European Central Bank
“First, a monetary policy which has price stability as its primary objective is a necessary condition for avoiding asset price bubbles and promoting financial stability. With the benefit of hindsight, it seems that some of the financial imbalances that built up prior to the crisis resulted from monetary policies which were not fully in line with the objective of price stability. Either the policies were also pursuing other goals, such as supporting economic activity and employment, or they were not focusing on the appropriate indicators of inflationary pressures, attaching, for instance, too much importance to output gaps and too little to monetary and credit developments. The first steps to take are to put monetary policy back on track—so that it focuses primarily on price stability—and to improve the underlying analytical framework. In particular, monetary and financial variables can provide the signal that the policy stance might be too loose with respect to the objective of ensuring price stability over the medium term. Second, a monetary policy that is appropriate for price stability might not suffice to ensure financial stability. Indeed, given that asset prices react more rapidly than other prices, they may overshoot their long-term equilibrium value and have undesirable effects on the financial system. If this were to happen, should monetary policy react, even if price stability is not at risk? I personally think that a case has not yet been made for such a course of action. It would imply that monetary policy follows two objectives with only one instrument, that is, the policy interest rate. Other instruments are needed and they belong more to the realm of macro-prudential supervision. Unless central banks are explicitly equipped with the appropriate macro-prudential supervisory instruments, they cannot be considered responsible for financial stability.”
JOSÉ DE GREGORIO
Governor, Central Bank of Chile
“Central banks should be concerned about asset prices. Severe misalignments from fundamentals may jeopardize financial stability. However, this concern does not justify that monetary policy should target asset prices. Indeed, this question arises from the wrong perception that the crisis was caused by monetary policies that did not take into account the soaring asset prices. In countries with an inflation targeting regime, asset prices affect monetary policy decisions to the extent that they affect inflationary perspectives. Going beyond this seems unwarranted for three reasons. First, it is not clear that an increase in interest rates would be capable of stopping an increase in asset prices and the required adjustments might be too large. Second, central banks should safeguard financial stability, and a large interest rate hike to prevent asset prices from rising could trigger financial instability. Finally, under inflation targeting, any interest rate movement that is inconsistent with the target may undermine credibility of monetary policy and weaken its effectiveness. In addition, a monetary policy excessively concerned about asset price collapses can create moral hazard. The strategy of monetary policy of turning a blind eye during the period of soaring asset prices and then, when the bubble bursts, reducing interest rates aggressively, provides an implicit insurance that makes bubbles more likely. In emerging markets, fighting bubbles via interest rate increases could be particularly damaging, because bubbles take the form of exchange rate appreciations. Tightening monetary policy during an asset price boom may induce further capital inflows and strengthen the currency. Adequate regulation of the financial system is crucial for preventing crises, and central banks should have a clear mandate on financial stability and the appropriate tools at their disposal to conduct macroprudential regulation. The challenge is to continue allowing financial innovation without inducing vulnerabilities such as those that caused the recent collapse.”
