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Central banks need not divine bubbles Samuel Brittan Financial Times 28/07/06 There are certain issues the mention of which acts as a conversation stopper for most people. An example is: “Should central bankers target asset prices?” But the problem will not go away. What is at stake is the long-run credibility of central banks. Even more important are the questions that it raises about the duration of the present happy combination of world economic growth and low inflation, which the National Institute of Economic and Social Research sees as the “strongest since the early 1970s”. It need not be as complicated as it can be made to seem. Think of a primitive economy in which the main transactions are between wheat growers and cattle rearers. At this stage there can be no inflation, but just the price of cattle in terms of bales of wheat or vice versa. Now introduce gold – or any other scarce product that is convenient to use as a means of exchange and standard of value. If the amount of gold in circulation doubles then the price of both cattle and bales of wheat should shoot up in terms of gold. In reckoning the rate of inflation in such a primitive society you have to look at both the gold price of wheat and the gold price of cattle. To ignore cattle on the basis that they are capital assets would be ludicrous. Yet that is the perceived central bank doctrine today. You just have to substitute urban property for cattle to see the absurdity. The riposte of central bankers is that they take asset prices into account in so far as they affect consumer price inflation. If your house doubles in value you will feel richer and spend more on items other than housing. There is nothing wrong in principle with this riposte except that it is a long-winded and tortuous process and can easily result in too little being done too late. The talk about bubbles – very rapid rises in the price of some assets which are then sharply and painfully deflated – is a side issue into which many have been trapped. If the Bank of England had an objective for asset prices, as it already has for consumer price inflation, the question of bubble spotting need not arise. If there is an inflationary movement in property prices, the target will sooner or later be breached irrespective of whether this is a long drawn-out process or the result of a sudden flurry in speculative activity. There are genuine problems in making asset prices a target variable. To start with: which assets to include and what weight they should be given. If you are going to include house prices there seems no warrant for excluding financial market assets which are an alternative way of holding wealth. But this, too, presents problems. If equity prices were to double this could represent the beginnings of an inflationary process that will spread to the whole economy. Alternatively, it could represent more optimistic expectations about growth and profits. But because something can only be done imperfectly, this is hardly a reason for not doing it at all. Recall the unofficial motto of the Habsburg empire: “If a thing is worth doing, it is worth doing badly.” Beneath the bland reassurances of government and international forecasters there are at least two very different appreciations of the outlook. There are those who look at the way in which the world economic upturn has continued without touching off inflation even in the context of an explosion in the price of oil nearing that of 1973-74 in its magnitude. These optimists can reinforce these conclusions by observing that emerging economies such as China and India are ready to put forth a stream of low-price products at the slightest sign of inflation taking off in the west. Yet there is another school of thought, which is more diverse and less clearly articulated, that includes unreconstructed monetarists who fear the dismissal of near double-digit growth of monetary aggregates will bring its nemesis. Then there are the old financial hands who look at rising oil, gold and other commodity prices which have traditionally been key leading indicators. How, then, should we proceed? Most central bank remits include supporting the policy of the government of the day, so long as this can be done without endangering price stability. As boom and bust are hardly the objective of any government, central bankers can act to minimise them. A lot can be done with normal short-term interest rates. It just means that policies will be modified to take into account asset price movements as well as forecasts of consumer prices. Yet there are no a priori reasons why there should not be some more weapons. There are old weapons that can be brought into use again without leading us back to a directed economy. Examples are overfunding and greater use of margin requirements on stock-exchange loans. Edward Heath, the former British prime minister, once compared the sole reliance on short-term interest rates to the actions of a one-club golfer. The stricture still applies.
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