Should, or can, central banks target asset prices? Twenty experts offer their views.

• Position: A SYMPOSIUM OF VIEWS

[ILLUSTRATION OMITTED]

Should, or can, central bankers target asset prices in their conduct of monetary policy? Over the past year, central bankers have engaged in a financial fire brigade in the aftermath of the bursting of the U.S. subprime mortgage bubble. But how difficult is it to identify bubbles and to avoid moral hazard without, from time to time, engaging in a fool's errand? In 1996, for example, Alan Greenspan in a famous speech before the American Enterprise Institute called the stock market "irrationally exuberant." The level of the Dow was 6,500 (compared to over 10,000 today in the aftermath of the worst financial crisis since the 1930s). As White House economic advisor Larry Summers has noted, "Greenspan's declaration was of a bubble that wasn't." Of course, years later Americans became irrationally exuberant about housing. That turned out to be a bubble that was. To what degree should central banks attempt to target asset prices? Is effective asset price targeting even possible?

[ILLUSTRATION OMITTED]

Yes, it probably means a compromise between consumer price objectives and asset prices.

SAMUEL BRITTAN

Columnist, Financial Times

The need to monitor assets is almost a cliche. But it is still correct.

Two specious arguments against are: 'How do you recognize a bubble? and "How do you fix a target? There may be no mechanical method of doing either. We may just have to rely on fallible human judgement, as in so many other walks of life.

Too many economists are in thrall to the dictum of a Dutch econometrician of seventy years ago who pronounced that you need as many weapons as objectives. By all means, try to develop a new weapon from bank capital ratios--in which I have little confidence. At the end of the day, normal monetary policy may have to be used too. This may mean a compromise between consumer price objectives and asset prices. So what?

A more important objection is that borrowers may go abroad to circumvent national borrowing restraints. But I do not believe that an agreed approach by G7 countries will be totally circumvented.

[ILLUSTRATION OMITTED]

But how would central banks resist pressures to prevent declines?

ALLAN H. MELTZER

Allan H. Meltzer Professor of Political Economy, Tepper

School of Business, Carnegie Mellon University, and

Visiting Scholar, American Enterprise Institute

Why have central banks resisted adjusting policy to limit alleged asset price bubbles or sustained movements? Many who urge them to do more avoid discussing the costs. First, how high would interest rates have to rise to prevent (say) a sustained 15 percent increase in stock exchange averages? Most policymakers in 1929, 1968, and 1988-89 thought the required rate increase would cause a deep recession. Second, should the authorities raise margin requirements instead? Much research is properly skeptical that margin borrowing rules are effective. Credit comes in many forms. Third, giving central banks multiple objectives is likely to achieve none of them. Policy should remain focused on at most a small number of attainable objectives. The Federal Reserve's record of achieving the dual objectives of stable growth and low inflation is not so successful that it makes adding other targets a good idea. And fourth, if the central bank agrees to respond to asset prices, how would it resist pressures to prevent declines?

In several papers, the late Karl Brunner and I included asset prices and the expected return to capital, along with output and prices in the demand for goods and money. Classical monetary theory teaches that if the central bank produces more money than the public desires to hold as real balances, the excess spills over into asset and output markets. Asset and output prices will rise if the excess continues. And the reverse is true if the central bank reduces real balances below the public's desired holdings. Asset prices are an essential part of monetary transmission in classical economics and in our models. Central banks that can separate the increase in asset prices that results from expected growth from the part resulting from expected inflation should use the information on expected inflation to reduce money growth. That would lower the speculative heat and keep the central bank concentrated on its dual mandate.

[ILLUSTRATION OMITTED]

No and yes.

MARTIN WOLF

Chief Economics Commentator, Financial Times

The answer is both "no" and "yes." The answer is "no" because no central bank should try to achieve specific targets for any asset or asset class. Nobody can know the "correct" prices. Moreover, it is impossible to target the prices of many different assets. The only assets whose prices have frequently been targeted by central banks are gold or foreign currencies. A case can be made for this, within the context of a return to fixed exchange rates. But that is irrelevant for big countries, such as the United States.

The answer is also "yes," because it is a mistake to treat asset price movements as important only to the extent that they affect the central bank's ability to hit a target for prices (or rate of rise of prices) of goods and services.

First, huge movements in asset prices, particularly if they induce swings in credit, may destabilize the economy. There is little benefit from stabilizing inflation if trying to do so mechanically destabilizes the economy. Second, if an asset price bubble does destabilize the economy, the central bank may find its ability to hit its inflation target, or stabilize the public's inflationary expectations, compromised. In a post-bubble situation, uncertainty about future inflation can increase dramatically, with some people expecting deflation and others expecting accelerating inflation. The central bank will then have lost some of its ability to hit its targets, partly because it has lost control over the economy and partly because it has lost the ability to anchor expectations.

It should, in short, be an aim of central banks to avoid huge asset price bubbles, particularly those accompanied by credit booms. They should not target prices precisely. But they should "lean against the wind." They do not have to use interest rates if they have other effective means at their disposal, such as targeted controls over borrowing or lending. But no central bank should ignore big swings in asset prices, even if it these movements do not indicate any immediate threat to its ability to target inflation. They are too dangerous for stability in the longer run.

[ILLUSTRATION OMITTED]

Without new tools, central banks cannot be responsible for financial stability.

LORENZO BINI SMAGHI

Member of the Executive Board, European Central Bank

First, a monetary policy which has price stability as its primary objective is a necessary condition for avoiding asset price bubbles and promoting financial stability. With the benefit of hindsight, it seems that some of the financial imbalances that built up prior to the crisis resulted from monetary policies which were not fully in line with the objective of price stability. Either the policies were also pursuing other goals, such as supporting economic activity and employment, or they were not focusing on the appropriate indicators of inflationary pressures, attaching, for instance, too much importance to output gaps and too little to monetary and credit developments. The first steps to take are to put monetary policy back on track so that it focuses primarily on price stability--and to improve the underlying analytical framework. In particular, monetary and financial variables can provide the signal that the policy stance might be too loose with respect to the objective of ensuring price stability over the medium term.

Second, a monetary policy that is appropriate for price stability might not suffice to ensure financial stability. Indeed, given that asset prices react more rapidly than other prices, they may overshoot their long-term equilibrium value and have undesirable effects on the financial system. If this were to happen, should monetary policy react, even if price stability is not at risk? I personally think that a case has not yet been made for such a course of action. It would imply that monetary policy follows two objectives with only one instrument, that is, the policy interest rate. Other instruments are needed and they belong more to the realm of macro-prudential supervision. Unless central banks are explicitly equipped with the appropriate macro-prudential supervisory instruments, they cannot be considered responsible for financial stability.

[ILLUSTRATION OMITTED]

Why not watch asset prices?

HELMUT SCHLESINGER

Former President, German Bundesbank

A reaction by a central bank to a dangerous development in asset prices certainly cannot be triggered when asset prices--share prices, house and land prices, and so forth--pass a prefixed target. But this is no reason that central banks should not pay strict attention to developments in the asset markets, not at least because of the consequences when a bubble bursts.

If central banks focus only on consumer prices and their expected developments, central bankers can lose insight into growing problems in the asset markets. In Japan during development of its great bubble at the end of the 1980s, there was no consumer price inflation, and consumer prices did not increase strongly in the United States in 1999-2000 and in 2006. Consumer prices gave no signal about the inflation of asset prices. But even this particular inflation has a strong monetary component. It can be seen in an analysis of monetary aggregates and in the magnitude of overall credit expansion. In the current...