Magazine article The International Economy , Vol. 23, No. 4
Should, or can, central bankers target asset prices in their conduct of monetary policy? Over the past year, central bankers have engaged in a financial fire brigade in the aftermath of the bursting of the U.S. subprime mortgage bubble. But how difficult is it to identify bubbles and to avoid moral hazard without, from time to time, engaging in a fool's errand? In 1996, for example, Alan Greenspan in a famous speech before the American Enterprise Institute called the stock market "irrationally exuberant." The level of the Dow was 6,500 (compared to over 10,000 today in the aftermath of the worst financial crisis since the 1930s). As White House economic advisor Larry Summers has noted, "Greenspan's declaration was of a bubble that wasn't." Of course, years later Americans became irrationally exuberant about housing. That turned out to be a bubble that was. To what degree should central banks attempt to target asset prices? Is effective asset price targeting even possible?
Yes, it probably means a compromise between consumer price objectives and asset prices.
Columnist, Financial Times
The need to monitor assets is almost a cliche. But it is still correct.
Two specious arguments against are: 'How do you recognize a bubble? and "How do you fix a target? There may be no mechanical method of doing either. We may just have to rely on fallible human judgement, as in so many other walks of life.
Too many economists are in thrall to the dictum of a Dutch econometrician of seventy years ago who pronounced that you need as many weapons as objectives. By all means, try to develop a new weapon from bank capital ratios--in which I have little confidence. At the end of the day, normal monetary policy may have to be used too. This may mean a compromise between consumer price objectives and asset prices. So what?
A more important objection is that borrowers may go abroad to circumvent national borrowing restraints. But I do not believe that an agreed approach by G7 countries will be totally circumvented.
But how would central banks resist pressures to prevent declines?
ALLAN H. MELTZER
Allan H. Meltzer Professor of Political Economy, Tepper
School of Business, Carnegie Mellon University, and
Visiting Scholar, American Enterprise Institute
Why have central banks resisted adjusting policy to limit alleged asset price bubbles or sustained movements? Many who urge them to do more avoid discussing the costs. First, how high would interest rates have to rise to prevent (say) a sustained 15 percent increase in stock exchange averages? Most policymakers in 1929, 1968, and 1988-89 thought the required rate increase would cause a deep recession. Second, should the authorities raise margin requirements instead? Much research is properly skeptical that margin borrowing rules are effective. Credit comes in many forms. Third, giving central banks multiple objectives is likely to achieve none of them. Policy should remain focused on at most a small number of attainable objectives. The Federal Reserve's record of achieving the dual objectives of stable growth and low inflation is not so successful that it makes adding other targets a good idea. And fourth, if the central bank agrees to respond to asset prices, how would it resist pressures to prevent declines?
In several papers, the late Karl Brunner and I included asset prices and the expected return to capital, along with output and prices in the demand for goods and money. Classical monetary theory teaches that if the central bank produces more money than the public desires to hold as real balances, the excess spills over into asset and output markets. Asset and output prices will rise if the excess continues. And the reverse is true if the central bank reduces real balances below the public's desired holdings. …