I Hope We All Agree Now: Central Bankers Should Pay Attention to Asset Prices

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“Should Central Banks Target Asset Prices?”   That is the question addressed by the current symposium in The International Economy (2009, no.4).

My answer: 

Alan Greenspan was right to raise the question “How do we know when ‘irrational exuberance’ has unduly escalated stock prices?”, which is what he actually said in 1996.    But he was wrong to conclude subsequently that monetary policy should ignore asset prices (or even that it should take asset prices into account only to the extent that they contain information about future inflation, as the Inflation Targeters would have it).    More specifically,
(1) Identifying in real time that we were in a stock market bubble by 2000 and a real estate bubble by 2006 was not in fact harder than the Fed’s usual job, forecasting inflation 18 months ahead;
(2) Central bankers do have tools that can often prick bubbles; and
(3) The “Greenspan put” policy of mopping up the damage only after run-ups abruptly end probably contributed to the magnitude of the bubbles ex ante, while yet being insufficient ex post to prevent the crisis from becoming the worst recession since the 1930s.    All three points run contrary to what was conventional wisdom among monetary economists and central bankers a mere two years ago.

As Claudio Borio and Bill White at the BIS pointed out before the financial crisis, many of the worst economic collapses of the last 100 years have occurred after excessively easy monetary policy had shown up in asset prices but not in inflation: US 1929, Japan1990, East Asia 1997, and now the US 2007.

A final point: “Targeting asset prices” is the wrong phrase.  The word “target” (for example, with respect to the money supply, exchange rate, or inflation) implies a number, or at least a numerical range.   I don’t know anyone who thinks that the central bank should contemplate setting a numerical range for the stock market.   Rather, the claim, which I think the evidence now supports, is that central bankers would be well advised to monitor prices of equities and real estate and to speak out, and eventually to act, on those rare occasions when asset prices get very far out of line.

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