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Taking asset prices seriously Samuel Brittan: Financial Times 29/08/02 Inflation targeting has worked so far. But central bankers will have to do more to pre-empt bubbles. Inflation targets have now been in use for about 10 years in many countries. The pioneer was probably New Zealand, followed not long afterwards by the UK. They have had a greater success than many people expected in keeping the inflation rate low while also reducing fluctuations in real growth. But rules for monetary policy in a paper currency world are not cast in stone. What was sufficient for the last decade may not be enough in the future. The main original fear about inflation targets was that they would be achieved at the expense of growth and employment. That was one reason why some observers, myself included, would have preferred an objective that explicitly included a growth element, such as for nominal gross domestic product growth. In fact, a regime of inflation targets alone has now come under criticism for a different reason. The fear now is not that real output has been neglected but that asset prices have been. There is a vigorous if rarefied debate about whether asset prices as well as consumer price inflation should be specifically targeted. The riposte of central bankers is that asset prices are in fact taken into account insofar as they are expected to contribute to future inflation. For instance, the property boom in the UK made some hawks on the Bank of England's monetary policy committee flirt with an interest rate increase this year. It has more recently been a factor delaying a cut. The deputy governor of the Swedish central bank has suggested that policymakers should deal with the aftermath of an asset price boom but should not attempt to pre-empt it. The critics argue, however, that this is not enough and action is needed to restrain an excessive rise in asset prices even if the inflation forecasts do not stray from the target range. One of the more moderate statements of the case is made by Michael Bordo and Olivier Jeanne in a paper for the Centre for Economic Policy Research*. Inflation, they argue, is not the only danger from an unchecked boom in asset prices. Such a boom carries with it the risk of a bust that will destroy the value of securities held by financial institutions and thus induce "a collateral- induced credit crunch". In their view the case for monetary restriction is greatest when the risk of a bust is large but when it can still be defused at relatively low cost. This means not delaying too long, as Alan Greenspan, chairman of the US Federal Reserve, did in the late 1990s. For, as the boom gathers momentum, more severe monetary restriction is required to puncture it. Central banks may then find themselves in the paradoxical position of having to induce a recession now to forestall the risk of a more severe recession when the bubble bursts. To the ordinary person it seems odd to talk of low inflation when property prices are going through the roof and newlyweds cannot get their foot on the housing ladder. As Harvey Cole, an economic consultant, says: "For those who doubt that asset bubbles are dangerously inflationary, the proof is simple. Does anyone deny that their bursting must be expected to have serious deflationary consequences?" Bordo and Jeanne cite as their two main examples of a big stock exchange-induced boom-bust cycle the US depression of 1929-33 and the Japanese one of 1986-1995. They agree with Milton Friedman that the depth and length of the depression were due to banking panics, which led to a collapse in the money supply. But the Wall Street crash contributed to this monetary contraction by reducing the value of bank loans and collateral. This led to a collapse of bank lending and the dumping of loans and securities, creating further asset price deflation. They argue that if the Fed had followed the views of Benjamin Strong, its chairman, and defused the stock market boom in 1928, the outcome would have been very different; and they conjecture the same for Japan in the late 1980s. The authors admit that assessing an asset price bubble is easier said than done. But is it, they ask quite reasonably, any more difficult than estimating the so-called output gap - how far output is from capacity levels - on which the interpretation of the current inflation target rules so often depends? A Bank for International Settlements study** argues, with an eloquence rare in such research papers, that it is not asset prices themselves that pose a threat to the stability of the financial system but the combination of rapid credit growth, rapid increases in asset prices and, sometimes, high levels of physical investment. In any case, their charts show that for many countries there is a strong link between asset price growth and the growth of private credit. The biggest policy problems relate to property prices. Bordo and Jeanne examine in detail experiences of Organisation of Economic Co-operation and Development countries since 1970. They find that out of 24 boom episodes in equity prices only three were followed by busts: Finland in 1988, Japan in 1989 and Spain in 1998. On the other hand they diagnose 19 booms in property prices in which 10 were followed by busts (two of which occurred in the UK in 1973 and 1989). Property price bubbles tend to be localised. This suggests that central bank policy may not be the best way to deal with them in monetary areas as large as the eurozone or the US - or possibly even the UK. Mr Cole suggests decoupling mortgage rates from the rest of the market. But such segregation is difficult in a free economy. He advocates requiring all institutions lending on property to place variable special deposits with the Bank of England. Such a scheme for the commercial banks, which existed in the 1970s, was wound up because it introduced distortions without being very effective. Nevertheless, unless anyone suggests something more refined, we could well see a return to such methods. In any case, policymakers will have to move on from targets aimed at inflation alone. The implicit model behind these targets is that all economic ills are reflected in inflation rates that are too high or too low - or are changing too rapidly or too slowly - and that, therefore, if these can be kept within sensible bounds all other ills will cure themselves. If a war with Iraq sends the oil price soaring, so that we once again witness that combination of inflation and recession known as stagflation, the model will be tested to breaking point. * Discussion paper 3398, May 2002 ** BIS working paper 114, by C. Borio and P. Lowe, July 2002
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