Academic journal article Atlantic Economic Journal

Public Messages and Asset Prices

Academic journal article Atlantic Economic Journal

Public Messages and Asset Prices

Article excerpt

Introduction

There have been several accounts in history when assets were traded at ever increasing prices followed by a sudden drop in price. Some use the term "bubble" to identify such situations. They argue that prices rose higher than the fundamental values of assets being traded for some time period. However, in the real economy there is always uncertainty related to the fundamental value of the assets; therefore, it is hard to argue if a bubble is indeed present or not. What is known is that when exuberant periods are followed by reverses in the value of certain classes of assets, economic growth is affected for some percentage of the time. (1)

The credit crisis losses that are linked to the recent real estate rise and fall are significant and continue to challenge policy makers in many developed economies around the world. The idea that a central bank should not target asset prices and that the most it should do is to "clean up the mess after the party is over" is coming under increased scrutiny. (2) The issue is especially relevant when there is a non-negligible probability of a systemic risk and when the "clean up" process might involve direct or indirect massive governmental bailout of the financial industry.

One way in which a central bank can affect inflated asset prices is to increase interest rates. However, such an increase might affect the real economy and many macroeconomists have questioned the desirability of a policy that targets not only economic growth and inflation but asset prices as well. An alternative to changes in interest rates could be to adjust the regulations and supervision of the asset markets. However, the costs related to an overhaul of the regulatory structure of the financial system might surpass the benefits in terms of the long term prospects for economic growth. (3) Another approach, potentially less costly but with relatively unknown benefits, makes use of the regular communication between the central bank and economic agents. (4)

The importance of communication between the U.S. central bank and the markets for efficacy of monetary policy started to be acknowledged in the 1990s. As a consequence, the Federal Open Market Committee's meetings are more transparent today than they used to be. The transparency of the central bank has usually been confined to its monetary policy affecting the inflation and economic growth targets. Policy makers have been reluctant to extend this openness to issues regarding asset prices. This paper uses an experimental design to derive implications for the use of communication in markets where assets are traded above the fundamental values.

In many markets information is not equally distributed among traders. Even when information is evenly distributed, different expectations in regard to the behavior of other traders can induce situations in which assets are traded at prices that are believed to be different from fundamental values. Abreu and Brunnermeier (2003) developed a theoretical model that explained departures of asset prices from fundamentals by a miscoordination between rational traders. In this setup a public message related to the fundamental value of the asset being traded can work as a coordination device among rational traders and help bring the price of the asset back to its fundamental value. In this paper we empirically test if this is the case.

Before proceeding further we should point out that the previous literature cautions us in regards to central bank use of public message in asset markets. First, the message might encourage traders to disregard their private information and rely mostly on the public information. If that is the case, prices in the economy might end up reflecting the central bank view of the economy and not having the signal power anymore argued by Hayek (1944). As Morris and Shin (2005) pointed out, if communication with the market is done on a regular basis, the central bank is looking more in the mirror by using in its analyses prices that it induced. …

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