In a January 17 speech, Federal Reserve governor Frederic Mishkin reiterated the Fed’s view, that its job does not extend to intervening in possible bubbles. By contrast, Ian MacFarlane, who recently retired as head of Australia’s Reserve Bank, and successfully intervened in that country’s housing bubble, feels that the current policy framework does not recognize asset inflation as a cause of instability, and sees the threat as serious.
From Mishkin’s remarks:
Despite the clear dangers from asset price bubbles, the question remains as to whether central banks should do anything about them….
A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets…
A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed….Yet there are several reasons to believe that this concern about burst bubbles may be overstated. To begin with, the bursting of asset price bubbles often does not lead to financial instability…Japan’s experience is that the serious mistake for a central bank that is confronting a bubble is not failing to stop it but rather failing to respond fast enough after it has burst….
A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble….Given the uncertainty about the effect of interest rates on bubbles, raising rates to deflate a bubble may do more harm than good.
In fairness, Mishkin didn’t say to do absolutely nothing. The Fed looks at various possible scenarios to determine how to respond to a break in prices. It also focuese on the risk-taking of the institutions it supervises, making sure they have adequate procedures and capital. And a recent Economist article discusses how regulators have increasingly used simulation as a tool.
Yet by contrast, Macfarlane’s views are vastly more forward-thinking. From the Sydney Morning Herald:
The biggest single challenge starts with the recognition that as an economy becomes more developed, its financial side grows a lot faster than its real side. As a result, economic outcomes will depend more on what happens in asset markets and less on what happens in the real side of the economy, such as in the goods and labour markets….If a major financial shock were to occur, such as a large fall in share or property prices, the effect on the economy would be greater than before.
So the central question is whether booms and busts in asset markets are more likely to occur in the future. No one knows, but there is no reason to believe that they will become less frequent or smaller. We know that since financial markets have been deregulated we have seen some pronounced asset price booms and busts, the most notable being the Japanese bubble of the 1980s and the high-tech share market bubble in the United States in the late 1990s. Both of these were followed by recessions. Australia had an equity and property boom and bust in the late 1980s, and a house price boom during the past decade that had many of the characteristics of a bubble, but fortunately it was not followed by a bust.
If it is likely that asset price booms and busts will be at least as common as over the past two decades and that their effect on the economy will be larger, what can monetary policy do about it? There was a time when we felt that monetary policy, by returning the economy to low inflation, would have a stabilising effect on asset markets…. But the broader evidence does not support the view that low inflation will prevent booms and busts developing in asset markets….Some have even gone as far as to suggest that low inflation may encourage the build-up in asset prices.
So, if low inflation does not provide any insurance, what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?…
Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.
First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.
Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community’s wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.
Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….
The interest rate decision is not the only decision that a central bank has to make ….[T]here are other ways of addressing the problem. Central banks have some credibility and authority, which can be used in a public awareness campaign to make people recognise the risks they are taking in plunging into an overheated market….At the Reserve Bank, we had some success with this approach during the recent house price boom….
But that still leaves the central bank with a very limited armoury with which to fight a potentially dangerous asset price boom – the interest rate, which it does not have a clear mandate to use, and public suasion, which is of limited effectiveness. How would it cope if it faced an asset price boom of the magnitude of those that occurred in the US in the 1920s or Japan in the 1980s? Not very well, I expect, but it would probably be held largely responsible for the distress that accompanied the bubble’s eventual bursting.
Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy. This has acquitted itself well over the past 15 years and is still working effectively, but over the next decade or two will probably face the type of challenges I have outlined.
No one is very good at picking the next major epoch, and we mainly react after the damage has been done. I am influenced by the fact that as the great inflation of the 1970s was building from the mid-1960s, no one, including the central bank, had a mandate to prevent it. As we struggled to come to grips with it, governments made decisions that effectively gave the central bank a mandate, and central banks worked out a framework that to date has been effective in dealing with it. No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.