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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”.