Syndicate content

The Arrival of Asset Prices in Monetary Policy

Otaviano Canuto's picture

by Otaviano Canuto

Once upon a (not long ago) time, there was a widely established set of blueprints for regimes of monetary and exchange rate policies expected to fit a full range of economies, and to serve as a guide for international monetary cooperation. That world is gone with the global economic crisis. As I explain in my new policy note, The Arrival of Asset Prices in Monetary Policy, a reshuffling of views on monetary and exchange rate policies will probably accompany new financial regulation.

Here are some of the issues I discuss in my note–and hope to discuss with you too:

  • Over the last decade, monetary policy has focused on inflation targeting without paying much attention to asset bubbles.
  • As the IMF’s new World Economic Outlook shows, well-behaved inflation and output performance are no guarantees against asset prices acquiring a cyclical life of their own. The even distribution of episodes of busts before and during the “Great Moderation” period, which started in the 1990s, until the current crisis is an illustration of that.
    Chart 1 - Asset price busts
  • The Institute of International Finance suggests that the beginning of the “Great Moderation” represented a structural break in the relationship between U.S. monetary policy and the overall global business cycle. Whereas previous monetary policy tended to drive business cycles, after the early 90s it became more responsive to capital flow cycles involving factors such as credit booms, binges of large current-account deficit financing, and finance made available to real-estate and other previously illiquid assets – roughly the same factors singled out by the IMF as leading indicators of asset price busts.
  • The powerful liquidity-generating machine made possible by that structural break in early 1990s turned out to be a “serial bubble blower.”
  • If monetary policymakers are to succeed in their macroeconomic stabilization mission, complacency with respect to asset price cycles will have to be left behind.
  • Signs of increasing macro-financial risks are demanding a response from policymakers. Either aggressive monetary policy reactions and/or the resort to time-varying macro-prudential instruments to dampen credit market cycles (acting thus on yield curves, rather than on short-term rates) should be put into action.
  • Those macro-prudential instruments may be “dynamic provisioning” rules – capital requirements of financial institutions that rise/fall faster than leverage – or discretionary setting of required reserves, in both cases reinforcing – and reducing the burden of – the direction taken by basic monetary policy. In any case, depending to a large degree on a judgment call about whether benign or malign factors are driving asset prices, policymakers should be ready to act.
  • A monetary regime that includes reactions to asset price movements (not targeting) and discretionary choices regarding interest rates and/or macro-prudential instruments is full of complex requirements. To see those, read my whole note.
  • There are those who still believe that the concern with a supposed propensity for bubble creation has been exaggerated. The subject is still open to fierce controversy and it will take time before it settles. In my view, however, the mainstreaming of reactions to asset price cycles into monetary policy is something that has probably come to stay.
  • The demise of the presumption of stability as the normal condition of financial markets has also shattered confidence in the self-adjustment of nominal exchange rates in currency markets. The loss of confidence on the effectiveness of stable centers of gravity for nominal exchange rates came as a corollary of the realization that protracted “over-shooting,” slow and unstable convergence toward interest rate parities, are common phenomena in foreign exchange markets.
  • It’s not by chance that the end of “corner solutions” as inevitable options for exchange rate regimes – along with the rising profile for international reserves as a buffer against shocks – are among the new “in” concepts in global money, as professor J.A. Frankel says.
  • In a world where discretionary decisions are deemed as the norm – rather than (notional) rules – the identification of sources of shocks, transparency and communication of decisions, as well as information exchange and consultation between monetary and financial supervisory authorities, all tend to become more riddled with international political economy factors.

Comments

Submitted by Anthony Obeyesekere on
Hi there, The URL to your note unfortunately is not working. I'm looking forward to reading it! :)

Submitted by Gilberto Tadeu Lima on
That monetary policy should pay close attention to asset prices should be self-evident, but unfortunately it took such a huge financial collapse for it to be duly appreciated by several efficient-market-friendly analysts (I am not including you among them). Targeting asset prices is probably not a sensible way of caring about and taking them into account, however, and discretion is really the name of the game here. But what kind of discretion? Your note correctly points out several issues that should be considered in that regard, and they actually lead one to conceive of several others. However, I was left wondering in what sense you are using “indeterminacy”. Are you talking about indeterminacy of asset prices, a feature that would eventually make them unsuited for some explicit targeting? In the literature on optimal monetary policy, there is this issue of the (potential) indeterminacy of the price level (of goods and services) when monetary policy is conducted having the interest rate as its instrument. However, this indeterminacy is usually removed when the so-called Taylor principle is followed. Are you suggesting that asset prices are likewise indeterminate, and that even the following of the Taylor principle would not remove it? In any case, would you be willing to consider that, even if targeting asset prices is not feasible, a typical Taylor rule could eventually incorporate some indicator of financial fragility such as some indebtedness ratio? As regards the implications of taking asset prices into account for regulation and supervision, does it mean regulators and supervisors should focus also on the financial practices sustaining a given asset-price trend? But given the unstable nature of Ponzi finance, would not regulation intended to detect financial practices underlying a Ponzi regime be always lagging behind financial instability? But would not an attempt at detecting speculative finance processes that may evolve into Ponzi finance processes be highly subject to the bounded rationality of regulators? Admittedly, one might claim that what really matters for economic stability is not how well asset prices are valued relative to a ‘fundamental value’, but the financial practices that sustain an existing price trend. Moreover, by focusing its efforts on discovering bubbles, the central bank may see bubbles where there may be none. Now, given that regulators themselves have bounded rationality, is not it also possible that, by focusing its efforts on grasping and decoding financial practices, they may see a worrying price trend where there may be none? I do agree that a central bank that decides to intervene to prickle a bubble puts itself in the odd spot of justifying its action, and will be condemned as ‘wealth killers’ and subject to tremendous socio-political pressures to leave asset prices alone. Hence the political economy of “taking asset prices into account” is quite complex. It is not simply “leaning against the wind”, it is sometimes more like “leaning against a small tornado”.

Submitted by Dan Biller on
Inflation Targeting, The speed of transmission and asset prices: The paper underscore the "demise" of the Taylor Rule due to asset prices. Maybe the problem is in fact broader that this. Inflation calculation as measured by CPI has recently come under scrutiny, and even GDP has measuring issues. If we turn to developing countries, using inflation targeting may further augment errors - some large countries for example use Wholesale Price Index (WPI) to measure inflation and others' impressive GDP growth have been questioned in several fora to be grossly over estimated. If we add the speed of transmission in some markets, which in fact is a critique of the Taylor rule given that policy makers face real-time information, one can't help but rethink the use of inflationary targeting. On the other hand, the alternative is not clear and the only potential policy advice that one can think is for Central Bankers to add a significant cushion their decisions being more conservative at times of positive growth and more loose at times of negative growth. The question remains how to determine this amount, which can also be assisted by reviewing the decision more often as information is available. In a sense, one could learn from the precautionary principle that is quite popular in climate change discussions. Yet, if a Central Bank has problems due to real-time information, imagine a Financial Regulator!: The paper implicitly argues that Central Banks are better equipped to regulate at least some asset markets (see additional comment below) via monetary policy instruments or similar instruments than financial regulators. Intuitively, this makes sense at least in part because of the transmission mechanism problem. Working via markets, monetary policy may impact asset prices faster than regulatory instruments. While this may still be slow, and the speed may be a point of contention (e.g. the current asset bubble bursted the moment the FED increased interest rates), it should be certainly faster than regulatory measures. Differentiating among asset markets as not all are equal may also be needed, but this caveat is missing from the note. When the note discusses asset markets, it seems in fact to be discussing more the real estate related asset market. Derivative Market Safeguards: If real estate asset markets metamorphosed as mortgage backed securities sold as a derivative market (e.g. oil futures), mark to market would be in place and margin calls would take place. At the day's end, regulators should know who have the "rope around the neck" and could act much faster to avoid collapse. Yet, somehow this was never in the cards, and one of the main issues is that no one knows the size of the damage. Mark to market is a lesson that even Central Banks could learn if they move to regulate asset markets of mortgage backed securities. Yet, the need for Central Bank intervention in other asset markets such as oil, commodities and even stocks is less clear.

Add new comment