Central banks main task over the past three decades has been to defeat inflation. But now they face an even tougher challenge: preventing even bigger booms and busts in economic activity caused by increasingly large swings in asset prices. Low and stable inflation was supposed to promote financial stability, yet greater stability in inflation and output has not been reflected in greater asset price stability.
Instead, the prices of assets, such as shares and property, have been subject to bigger swings over the past two decades. It seems clear that low inflation does not guarantee financial stability. By focussing too much on inflation, the economy is pushed into deeper recession and can cause deflation. Deflation is much more damaging to economic stability than inflation. It deepens recession because it increases the real burden of debt and encourages consumers to delay purchases in hope of lower prices later.
Swings in credit growth and asset prices have always played an important part in business cycles, but their role seems to have increased of late. Financial deregulation and innovation have increased the scope for more pronounced financial cycles, which in turn can amplify the business cycle. For instance, rather than holding loans on their books, banks now bundle loans into securities and sell them on the secondary market. The resulting stream of liquidity allowed the banking system to lend more during the boom. Cycles in credit and asset prices usually occur in tandem, reinforcing one another. Rising asset prices boost growth and make it easier to borrow by raising the value of collateral.
Faster growth in credit and output then feeds back into higher asset prices. When asset prices fall, the process goes into reverse. More households’ now own houses and shares, so swings in asset prices have bigger effect on the economy. Sometimes it can be devastating for the nation’s economy and sends ripple effect on the neighbouring countries.
Should central banks try to curb unsustainable credit and assets price booms? The usual answer is that policy makers are unlikely to make better judgments about risk and sustainability than does the private sector. But as John Keynes said, “A sound banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way, along with his fellow, so no one can really blame him”. Central bankers are less likely to run with the herd. They have longer time horizons and different incentives, as well as a better understanding of feedback between the financial sector and the real economy, so they may respond differently to the same information.
One strategy is for capital requirements to be increased during the boom if supervisors see a potential increase in risk. Or to cool a housing boom, regulators could restrict the maximum mortgage as a percentage of a property’s value. But it would be tricky to identify exactly when this should be done. If regulators got it wrong, they might undermine the efficiency of the banking system.
The alternative is to raise interest rates to check an unsustainable rise in credit and asset prices. However, not only is it difficult to identify financial imbalances early enough to act, but central banks do not have a mandate to prick bubbles. They already do take account of rises in share or house prices to the extent that these feed into higher spending and hence future inflation, but asset-price and debt bubbles can build up with little immediate effect on inflation. Higher interest rates would be hard to explain to the public of today’s inflation was well under control.
Moreover, there are doubts about the effectiveness of higher interest rates in containing share prices. Interest rates are more like a blunderbuss than a laser-guided weapon. A small rise in rates might be counterproductive if it increased confidence in the central bank’s anti-inflation commitment and so boosted asset prices further. A big rate rise would probably work, but it might lead to a deep recession.
Most central bankers believe that they should not raise interest rates to stop a boom in asset prices and credit but rather adopt a wait and see strategy if the asset price bubble bursts and then respond to the adverse consequences. Tightening monetary policy and close supervision are required to rectify the financial imbalances that threaten the economic, social and financial stability of the nations and countries around the world. Indeed speculative excesses in asset prices and credit flows might occur more frequently in future, thanks to the combined effects of financial liberalization and a monetary policy framework that concentrates on inflation but places no constraint on credit growth. The current conventional wisdom that central banks will reduce economic and financial instability by keeping inflation low and stable flawed. Low inflation is no guarantee of economic stability.
Emphasis on asset prices alone is erroneous. It is when a boom in asset prices is combined with a big increase in debt that it becomes really dangerous, because when house price or share prices fall, borrowers get squeezed. There is therefore, a stronger case for tighter monetary policy when surge in asset prices goes hand in hand with rapid credit growth. Simultaneous explosion in asset and credit prices provides a useful warning for financial troubles ahead.
Central banks should act when are certain that they are dealing with a bubble in the economy. It is true that central banks have to face uncertainties all the time. It is arduous to grasp with the ever-changing financial markets of the world. The real issue is whether central bankers are prepared to start arguing the case for raising interest rates in response to serious financial imbalances, and whether they are prepared to live with unpopularity if they burst a bubble in equities or house prices.
Analyzing strategically about how the global economy works and what role monetary policy should play have changed dramatically in recent decades. From the 1950s to the 1970s the main objective of monetary policy was full employment. Once inflation took off, governments abandoned full employment to make the control of inflation their number one priority. Persuading the public that credit and asset-price bubbles are just as bad for them as inflation is surely no harder than making the switch from fighting unemployment to fighting inflation. Taking control of inflation sometimes leads to deflation, which leads the economy into red. Once deflation takes its roots in the economy, it gives central bankers a chance to redesign and reframe their strategic policies to take the economy out of recession before it goes into depression.
Deflation has emerged from simultaneous slumps in the world’s three major economies. Prices drop because there’s too little global demand chasing too much global supply-everything from steel to pizza. The engine is sputtering. In 2001, Germany GDP grew a meagre 0.6 per cent; this year is it is expected to grow 0.4 per cent. Far from offsetting the US slowdown, Europe and Japan [almost a third of the global economy] are aggravating it.
Fed’ s decision to cut the interest rates 2-weeks back implicitly recognizes an unspoken reality; Americans have not being bolstered from abroad. European union’s economy will grow only about 1.2 per cent in 2002 compared to 2.3 per cent for the United States. The irony is unavoidable. Germany’s is Europe’s sick man while Japan rests in Asia. Two decades ago, these countries seemed poised to assume leadership position in the global economy and threaten to challenge other countries. Now these nations are facing severe teething problems like a newborn child.
During the past century, every monetary rule has broken down in the face of changing circumstances: the Gold Standard, the Bretton Woods System of Fixed exchange rates and monetary targeting. Now it seems that strict inflation targeting is not the promised panacea either. Central bankers’ fixation in short term price stability can blind them to other important signs of financial imbalance. In turn, those imbalances can cause deeper recessions and even a future risk of deflation. Without some redesign of monetary policy to take more account of swings in credit and asset prices, economic booms and busts could well become more disruptive in the foreseeable future.
Central banks main task over the past three decades has been to defeat inflation. But now they face an even tougher challenge: preventing even bigger booms and busts in economic activity caused by increasingly large swings in asset prices. Low and stable inflation was supposed to promote financial stability, yet greater stability in inflation and output has not been reflected in greater asset price stability.
