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Saturday, December 26, 2009

Five questions on asset prices and monetary policy

Howard Davies was a deputy governor of the Bank of England, and the first head of the UK FSA. He is one of the world's leading thinkers on financial regulation and monetary policy, and one of the people who combines skills in both finance and monetary economics. In a recent article, he focuses on the five interesting questions about central banks and asset prices. Everyone interested in monetary policy today needs to ask themselves these five questions.

Q1: Should central banks target asset prices?


Davies points out that the consensus view is that central banks should remain focused on inflation targeting and not target asset prices.

However, pretty much everyone would agree that information from the world around us, about asset prices, is useful for forecasting inflation and output, and should be used in figuring out what values for output and inflation we put into our Taylor rules (whatever they might be).

So it seems that on this question, there is consensus: Asset prices are (and have always been) useful inputs in monetary policy formulation, but monetary policy should continue to do inflation targeting and not asset price targeting.


Q2: Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

Any reasonable CPI must have house rent in it, and through this, a boom in house prices and thus rents will get reflected in the CPI. This would give one more channel through which asset prices would directly influence a traditional inflation-targeting central bank.


Q3: Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

This is controversial territory. Some economists believe it is possible to ask central banks to make a call on when asset prices are misaligned.

I am personally skeptical about the extent to which this is possible. It is always easy to look back, ex-post, and say that it was obvious that US house prices were way off in 2006. But how many of the people who say this today were shorting US housing then?

Making a call about asset price fluctuations is hard even for a well motivated hedge fund manager. It is doubly hard in the public sector given the peculiar combination of skills and incentives that are found within central banks. The people with real skill in these things are unlikely to choose to work in a central bank; years spent in a central bank do not hone skills at market timing; the public will be very irritated if a central bank calls wrong.

So overall, I'm skeptical about the extent to which central banks (past or future) can usefully make calls about when asset prices are out of whack.


Q4: Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion?

Even if you knew that asset prices were grossly wrong, interest rates seem to be a very blunt tool, which inflict collateral damage all around the economy. Davies quotes Mervyn King who said two months ago: Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.


Q5: Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?

I think there is a good case for building some kinds of counter-cyclicality into financial regulation. But operationalising this is hard.

It should be feasible for financial regulators to have three manuals which govern boom times, normal times, and recessions. Full public disclosure of these three manuals is, of course essential, to avoid the usual issues of transparency and consistency. The question is: When would you flip from one manual to another?

Doing this based on asset prices runs into the difficulties articulated above. How is a civil servant to know when asset prices are in a boom or a bust?

Doing it based on business cycle conditions is more objective and feasible. It should be possible to setup indicators like Eurocoin which give low latency information about a coincident indicator. This could be used to drive rules about when we go into each of the three manuals. I personally think this would be useful.

Such efforts can be rationalised on the narrow ground that we seek to reduce the extent to which finance is a source of pro-cyclicality in the economy. If this is done right, it would reduce the amount of heavy lifting that monetary and fiscal policy have to do by way of stabilisation.

You don't have to have a `financial markets are irrational' view to support this. All you have to believe is that the existing structures of financial regulation are a source of pro-cyclicality. If that much is agreed, then there is a case for changing the framework of financial regulation so as to reduce the extent to which this is the case.


  1. for a supposedly pro free markets blog, this dogmatic belief in the central banks baffles one.
    why is it difficult for free market champions to make that logical conclusion why central banking like all other central planning is not only inefficient, they also cause the business cycle amplitudes to vary and their actions,however intelligent they maybe, lead to all sorts of unintended consequences.

    i can understand those with socialist leanings crying for a monopoly over the money supply and interest rates, but free market types, too?.thats disappointing.
    or is the free market idea too radical?

  2. Glad to see a discussion on asset inflation vs cpi/wpi.

    Until the last question it felt like it would suffer from the common limitation in most such discussions - focus remains on asset prices and difficulty in determining whether asset prices are unreasonable and hence concluding that nothing can be done.

    I think most agree that by looking at a price, a number.. one can't say much but why should policy not look at causes/effects of asset inflation? After all asset inflation is typically a symptom and the reason can be something benign or malignant. If asset inflation is associated with a drastic increase in debt and not by increased investment out of savings, at the very least a review of debt levels, leverage and lending practices should be in order?

    Greenspan admitted that he knew about bad subprime lending practices in 2005 but felt that banking regulators could/should do nothing about it. That cannot be acceptable.

    Atleast Howard has a supposedly objective and feasible suggestion that goes beyond doing nothing. Way to go...

  3. I jumped to another blog from this one and there were some related thoughts on financial reform from a China perspective:

    Pace of change

  4. (There were some errors I made in my earlier comment. I have deleted that entire comment. This comment is the corrected one)

    I think policies, once finalised, should not be changed frequently. Frequent changes entrenches the unhealthy practice of intense lobbying that we see today in all governments, markets and industries.

    It is fine for asset prices to have a free run but then when there is a crash in their prices there should be no bailouts by governments. If some entities are to be understood as "too big to fail" then they should not be allowed to get that big in the first place. This is so because when such "too big to fail" companies are getting big their entire huge profits are pocketed by their shareholders and managements. Taxpayers do not benefit as much from their successes and so there is no need for the taxpayers to participate in their losses when governments, under the influence of lobbyists, bail them out.

    Three policy manuals for three different asset cycles, and making them open for public scrutiny, is very fine but they should be consistent with a fundamental capitalist principle: the higher risk you take the higher profits you get to keep (which is the incentive to take higher risks in the first place) but you should have the ability to bear higher losses if you fail.


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