Inflation, Asset Markets, and Economic Stabilization: Lessons from Asia

By Browne, Lynn Elaine; Hellerstein, Rebecca et al. | New England Economic Review, September-October 1998 | Go to article overview

Inflation, Asset Markets, and Economic Stabilization: Lessons from Asia


Browne, Lynn Elaine, Hellerstein, Rebecca, Little, Jane Sneddon, New England Economic Review


In the 1980s, a new convention emerged in the economics profession - that central banks' primary, or even single, responsibility should be controlling consumer price inflation. Such a view, in various forms, has been around for a long time.(1) But the idea gained broader acceptance as the dramatic rise in world inflation during the 1970s, coupled with a broad deterioration in economic performance, seemed to highlight the pernicious effects of rapidly rising prices, just when various theoreticians were arguing that monetary policy was prone to an inflationary bias. Moreover, while aggressive efforts to combat inflation by the Volcker Fed and central bankers in Japan and Germany led to recession in the early 1980s, the output costs of disinflation were not as severe as many had feared and the subsequent recovery and expansion in both the United States and Japan reinforced the notion that if only consumer price inflation could be brought under control, economic growth would take care of itself.

By the 1990s, this view was gaining credibility within policy circles, and various countries mandated that their central banks make inflation their primary, if not their sole, focus - although these mandates usually contain an escape clause for an economic shock that affects employment and growth severely.(2) New Zealand and Canada were two leaders in this regard. Meeting a low inflation target also became a major criterion for joining the European Monetary Union, and ensuring price stability is now the main goal of the European Central Bank. Moreover, while the concept of inflation targeting originated in the industrial world, governments in many developing countries now adopt annual inflation targets, and achieving low inflation is widely perceived as a sign of "success" under IMF surveillance and in international capital markets.(3)

Here in the United States, this orthodoxy has never gained official status, although legislation advocating an inflation target was proposed.(4) Rather, the U.S. policy goal remains promoting stable long-term growth, and the policy approach remains eclectic. (Of course, even in countries with an inflation target, like Britain and Germany, policymakers admittedly watch and react to a variety of indicators as practicality requires.) Nonetheless, the strong performance of the United States during the mid 1990s, with inflation declining even as the unemployment rate fell below most estimates of full employment, seemed to reinforce the case for a focus on price stability.

That Japan had experienced a severe recession early in this decade that was not preceded by a significant rise in inflation was not generally seen as a challenge to this view. Although the country had experienced an asset price "bubble" to which monetary policy mistakes may have contributed, Japan's ongoing problems were widely laid at the door of a directed model of industrial development that had outlived its usefulness; an unwillingness to deal decisively with its banks' bad loan problems; and more recently, an overly stringent fiscal policy as the economy struggled to recover.

Now, however, world policymakers are dealing with a currency and financial crisis in East Asia that has produced serious recessions in South Korea, Indonesia, Thailand, and Malaysia; threatens their neighbors; and is adversely affecting trading partners and other nations seemingly far removed.(5) Yet the Asian countries had not previously experienced any pronounced acceleration in consumer price inflation; nor had they suffered the deterioration in their fiscal position or other economic "fundamentals" most commonly viewed as forerunners of financial crisis.(6)

The recent problems in East Asia, as well as the earlier one in Japan, raise the question of whether such a concentrated focus on consumer price inflation has become tunnel vision, dulling the sensitivity of policymakers and market participants to other signs of overheating. …

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