Tuesday, May 22, 2007

Monetary Policy and Dragon Slaying

The objectives of monetary policy are very different in different economies. For example, Singapore seeks to stabilise the exchange rate against a basket of other currencies. Many central banks seek to maintain the inflation rate on consumer goods in the low single-digits (referred to as "inflation targeting"). The Federal Reserve in the United States seeks to "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," although in recent years its behaviour has looked much like an inflation targeter.

Stepping back, each of these objectives is chosen based on an over-arching concern that monetary policy should increase stability in the economy. Because economies have different structures, different objectives may be appropriate for different economies, and at different times.

To understand why "inflation targeting" is so popular today, a little history is helpful. The 1970's were a disastrous period of monetary policy. Inflation rates increased into the high teen's in many developed economies, reducing economic stability. Inflation targeting was an appropriate and timely foil to this problem. It was pioneered by one of the worst performing central banks in the developed world over this period, the Reserve Bank of New Zealand, but was quickly adopted by other countries as a transparent way to maintain stable inflation at minimal cost to the real economy.

So the inflation dragon has been slayed; does that mean that central banks can relax, knowing that they are achieving their objectives? Unfortunately, the answer is "no." While price stability is important, it is just one element in achieving a stable economy. Further, there is increasing evidence that slaying the inflation dragon has allowed another, potentially more ominous dragon, to grow in its absence.

What I am talking about here is asset price bubbles. Low and stable inflation over a decade or more has ensured that consumers and investors at large have come to expect low inflation in the future. They know that if the inflation rate jumps, the central bank will quickly respond by increasing interest rates, stabilising inflation. Thus, not worried about surprise inflation, they are content with moderate wage increases, sustaining low inflation as an equilibrium.

With little inflationary pressure, central banks have been able to increase the money supply (or equivalently lower real interest rates) below historical levels. The resulting cheap credit and excess liquidity has led to increased demand for assets, pushing up equities and real estate prices in many countries. To some extent, this is an appropriate outcome: lower real interest rates imply that the opportunity cost of owning equities or real estate is lowered, encouraging higher real prices. My concern is that this process has gone too far, and the prices of many assets now exceed fundamental levels. And when asset price bubbles develop, they must eventually burst.

Examples of possible asset price bubbles vary by country. In the US, UK, Australia, New Zealand, Spain, etc, I would point to real estate as a probable bubble, and one that is starting to burst in the US at least (see my earlier posts here, here, and here). For China, the bubble appears to be equities (see my earlier posts here and here).

Suppose that the arguments I'm making here are correct. Because boom-bust cycles are disruptive for the real economy, monetary policy is not achieving its ultimate objective of economic stability, regardless of its effectiveness at stabilising prices or exchange rates.

What should we do about it? That's the million dollar question! In principle, existing monetary policy tools could be used to try to prevent asset price bubbles developed, but that may require extreme changes in interest rates, which themselves would be destabilising. I'd also be very skeptical of the ability of any central bank to correctly detect bubbles in the long run. That is because it is not always clear whether a rapid increase in asset prices represents a bubble.

But there are some simple first steps that a central bank could take. For example, if inflation is benign but asset prices are roaring ahead, the central bank should be hesitant at cutting rates, and maybe should raise rates at the margin.

These are just my preliminary thoughts on this important topic. I think that this is one of the potential big new areas where central bank behaviour is likely to change in the coming decade, although I have no idea at this point what form such changes are likely to take. I'll blog more on this topic in the near future.....

1 comment:

Mike said...

economists used to talk about Great Depression, Great Inflation and Great Moderation...maybe it's time for a Great Speculation!

one question haunts me recently. it is a stylised fact that monetary policy should have no long run real effect, the so-called neutrality of money. However, the recent liquidity binge have so widespread impact on asset market(m&a, private equity, hedge fund, subprime, etc), is it still true to claim that this time money will remain neutral? or the long run has been prolonged?