Academic journal article The Cato Journal

A Dangerous Brew for Monetary Policy

Academic journal article The Cato Journal

A Dangerous Brew for Monetary Policy

Article excerpt

It is a pleasure to join you at Cato's 28th Annual Monetary Conference. In preparing today's remark, I noted that this year's topic of how monetary policy should deal with asset prices was also discussed here in 2008. The speakers at that time expressed a wide variety of views and opinions. The fact that this important question continues to resurface here and at other prominent meetings in recent years suggests that a consensus has yet to emerge.

Today I will offer one policymaker's views on a few of the key issues. And I do mean one policymaker's views, as my remarks do not necessarily represent those of the Federal Reserve Board or my colleagues on the Federal Open Market Committee.

It is probably only a modest stretch to say that the prevailing view among many, if not most, monetary policymakers has been that a central bank should not make asset prices a direct focus of monetary policy (see Kohn 2009, Posen 2009, Bernanke and Gertler 2001, and Bean et al. 2010). Yet, the housing boom, its subsequent collapse, and the financial crisis that followed are viewed as central elements that gave rise to the Great Recession. These events have once again renewed the debate about whether a central bank should give asset prices a direct role in policy (see Cecchetti et al. 2000, and Roubini 2006).

The severity and financial nature of this recession has led many forecasters to anticipate a protracted period of modest economic growth, accompanied by a slow decline in unemployment. Some even worry that the economy might fall into a deflationary trap. I am not one of them. Indeed, I am more optimistic than many about the future path of the economy. However, I share the frustration of many with the pace of recovery.

In light of these events and the outlook, it is easy to understand wily many would want to reexamine the role of central banks in preventing such a crisis. How should Fed policymakers best ensure price stability and maximum sustainable growth? What role do booms and busts in asset prices play in fomenting economic and financial instability? To what degree should monetary policymakers allow asset prices to directly influence the course of monetary policy? This latter question is the focus of today's discussion, and it remains a thorny issue.

Monetary policy, as conducted by the Fed, is typically guided by traditional concerns of monetary policymaking. These include a measure of output growth, and the current and expected rate of inflation relative to a target. The exceptions have been "lender of last resort" actions--such as lowering interest rates rapidly in the face of a liquidity crisis.

So, how should asset-price behavior influence the path of monetary policy? One point of view stresses that movements in asset prices can provide useful information about the current and future state of the economy, including the prospects for inflation. In this case, asset prices would be just one of many signals that monetary policymakers should consider as inputs to their forecasts of output and inflation. An alternative perspective has the stance of monetary policy reacting directly to movements in asset prices in an attempt to reduce or eliminate the formation of asset-price bubbles that could be damaging to the economy.

Asset Prices and the State of the Economy

Let's consider each of these arguments. The first rationale for paying attention to asset prices should not be very controversial. In my view of monetary policy, the central bank should systematically vary its target interest rate in line with movements in an estimate of the real interest rate. In the face of economic shocks that result in an increase in the real interest rate, the central bank should respond by raising its target rate commensurately, as long as inflation is at or near its target. Failing to do so will lead to higher inflation in the future. Similarly, if shocks cause a decrease in the equilibrium real interest rate, then the central bank should lower its target interest rate to avoid disinflation. …

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