Sensible suggestions for monetary policy vs bubbles

Comments on Wolfgang Munchau, Financial Times “How to prick bubbles”, 26/10/2009, http://www.businessspectator.com.au/bs.nsf/Article/How-to-prick-bubbles-pd20091026-X6SZL?OpenDocument&src=sph

Munchau has some excellent suggestions to offer to central banks on how to use monetary policy to prick bubbles.

The most important point is that monetary authorities should not just focus on the stability of price, but also assets prices.

Once such thinking is held by central banks, they need to develop new tools to best to do that. Munchau did not touch this point, though.

His suggestions are so innovative so that I quote them in full:

“Remember the debate about whether central banks should prick bubbles? It was not too long ago that simply asking the question incited abuse. While pricking bubbles is now considered a suitable subject for polite conversion, there is still no agreement on what to do or how to do it. Since bubbles are already building up in several segments of the financial markets, it is time to think about this question in detail.

As I argued last week, there are some deep-rooted causes of the proliferation of bubbles – among them the size of the financial sector; the too-big-to-fail problem; and the banks’ renewed lust for risk. Governments have not been addressing these causes. Central banks will not provide the cure either, but they can address some of the symptoms. Symptoms matter.

Some economists, reluctant to let go of the comforting world of rational expectations, still tell us it is impossible for a central bank – or anyone else, for that matter – to call a bubble. This is baloney. When looking at house prices, just look at price-to-rent and the price-to-income ratios, sales volumes and credit statistics, and you know everything you need to know. Almost everything else central bankers do is more difficult than calling a housing bubble.

The most persistent argument against pricking bubbles is that monetary policy cannot target consumer and asset prices with a single instrument – the short-term interest rate. This statement is both trivially true and misleading. One can use existing instruments more flexibly, and one can also add new ones. Based on these principles, I have four proposals.

The first is the use of alternative regulatory instruments if available. This is not always possible but, where it is, such instruments could be deployed in the housing market, for example, where one could vary the ceiling on the loan-to-value ratio according to market conditions. Since housing bubbles are almost always credit-driven, an anti-cyclical LTV could encourage or discourage risky mortgage lending. Such a tool could be deployed by local central bank branches – or national central banks in the eurozone – since many housing bubbles are regional: east and west coast in the US, Spain and Ireland in the eurozone.

Second, central banks should use existing leeway in their monetary policy. In an ideal world, a single policy instrument should focus on a single target, but this is not an ideal world. Central banks will have to master the art of targeting some measure of price stability, as well as including asset prices in their consideration. In practice this would mean that a central bank should, by reflex, not always choose the lowest interest rate consistent with its definition of price stability. It should choose a higher rate in the presence of a bubble. With hindsight, if central banks had not cut interest rates quite so aggressively in 2003-04, we would probably still have had a bubble, but perhaps a smaller one.

Third, central banks should accompany their model-based economic forecasts with an analysis of monetary and financial conditions. The workhorse economic forecasting models used by central banks are built in such a way that they cannot capture financial shocks and bubbles. This makes them worse than useless in a world characterised by persistent financial instability. An analysis of monetary conditions and financial flows can provide at least a useful complement to now defunct models.

Finally, central banks must coordinate with one another. While each has the tools to establish price stability in its own jurisdiction, many asset prices – equity prices and housing prices in particular – tend to correlate globally. It makes no sense for the central bank of a small or medium-sized country to try pricking a domestic equity bubble. But if central banks act jointly, they could send out a strong signal. Just imagine what would happen if the world’s three leading central banks shorted Intel, BMW and Toyota.

I am aware that these measures are not going to solve the problem of financial instability. In the absence of deeper reforms in the financial sector, nothing will. But they might still be useful firefighting tools. It may be better to try out at least some of them than to pretend that the problem will simply go away.

I suspect strongly that we are already in another bubble in the global equity and bonds markets, and also in sections of the commodity markets. These may burst well before the world economy recovers from the most recent bubble. Central banks should eventually prick them before they cause calamity.

It may not be the time yet to deploy an anti-bubble strategy. But we sure need to put one together.

Copyright The Financial Times Limited 2009”