Leaning Against Thin Air: on the inconsistencies of a monetary policy debate (original) (raw)

Should Monetary Policy Respond To Asset Price Bubbles? Revisiting the Debate

National Institute Economic Review, 2008

Recent events have highlighted the importance of asset prices to central bank decisions. We argue that, in response to asset price bubbles, central banks should ‘lean against the wind’ (LATW hereafter). Even if the bubbles themselves are not significantly affected by LATW, macroeconomic performance can be improved if monetary policy reacts to asset price misalignments over and above the reaction to fixed horizon inflation forecasts. In addition, it might reduce the probability of bubbles arising at all. This article restates the case for LATW, and reviews the debate. In particular I respond to various criticisms that have been made against LATW and briefly consider alternative policies designed to make the financial system less cyclical.

Rethinking Monetary Stabilization in the Presence of an Asset Bubble

SSRN Electronic Journal, 2000

This paper addresses three important questions: how should monetary policy respond to stock market booms, what causes stock market bubbles and can monetary policy pop them. These questions arose during the recent stock market bubble during 1995-2000 and its collapse during 2000-1. To answer these questions we rapidly review the lessons learned from the Fed's response to the stock market boom in the 1920s and the lessons learned from the response of the Bank of Japan in the 1990s. The conclusion of the paper is that an asymmetric response of monetary policy to the stock market booms is appropriate: neutral in stock market booms unless they cause inflation, monetary ease after a stock market bust to dampen the effect on output and if necessary to provide liquidity to the financial system. The theoretical bubble literature and the U.S. experience in the 1920s provides little evidence that monetary policy can pop bubbles and attempting do so is potentially costly in terms of lost output.

How should monetary policy respond to asset-price bubbles?

2005

We present a simple macroeconomic model that includes a role for an asset-price bubble. We then derive optimal monetary policy settings for two policymakers: a skeptic, for whom the best forecast of future asset prices is the current price; and an activist, whose policy ...

Pricking Bubbles in the Wind: Could Central Banks Have Done More to Head Off the Financial Crisis?

Australian Economic Review, 2009

Regulators, commercial and investment banks, hedge funds and rating agencies have all borne some blame for the current global financial crisis, but could central banks have done more? It is argued in the lecture that in a number of ways central banks should have paid more attention to asset bubbles, which have high output costs. Asset prices, especially housing prices, should be identified as an explicit factor in the consideration of policy. More generally, central banks should adopt policies that 'lean against the wind'.

Speculative bubbles, speculative attacks, and policy switching

Journal of International Economics, 1996

As one indicator of the widespread impact this research has had, I note that I easily found close to one hundred citations of 'Market fundamentals versus price-level bubbles: The first tests' (which appeared in the Journal of Political Economy in 1980) and more than fifty citations of 'Collapsing exchange rate regimes: Some linear examples' (which appeared in this journal in 1984). As the volume's title suggests, the papers are collected in three parts, on bubbles, speculative attacks, and process switching. In each part, the work is a creative and inspiring mix of monetary economics, statistics, and economic history. Many of the papers are concerned with linear asset-pricing models, in which an asset's price is a function of an exogenous variable (a fundamental) and of the expected change in the price. In studies of hyperinflation the price is the general price level, given by inverting Cagan's money-demand equation, and the fundamental is the money supply. In studies of speculative attacks and process switching the price is the nominal exchange rate, governed by the monetary model of exchange rates, and the fundamental is the relative money supply or relative velocity. One of the main themes of the book is that this standard relationship can be used to explain events in unusual episodes of financial history including the ends of hyperinflations, tulipmania, and speculative attacks. The general solution to this linear difference equation includes two terms: the first is the present-value of the stream of expected future fundamentals; the second grows autonomously over time. Flood and Garber argue persuasively that our first presumption should be that the second term (the bubble) is zero, so that prices reflect only fundamentals. In Part I of this volume, they support this argument in two ways. First, they show that

Asset Price Bubbles and Central Bank Policies: The Crash of the'Jackson Hole Consensus

This paper reexamines the main arguments of whether or not monetary policy should respond to asset bubbles. The question of how the central bank should respond to an asset bubble can be reformulated in two ways. First, how does the central bank respond while an asset bubble is growing, and second, how does it respond after the bubble bursts? There has been strong agreement among economists that a central bank should respond to the bursting of a bubble by aggressively decreasing the Fed funds rate to minimize the adverse impact of financial instability on the real economy. However, there is no clear answer to the question of how the central bank should respond to an asset bubble before it bursts. If there is evidence that the asset price bubble is contributing to inflation, then there is general agreement that the central bank should respond. But what if prices remain stable? These issues are critically reviewed and the conclusion is reached that the high costs associated with the 2007-2009 financial crisis have encouraged the development of a new central bank policy paradigm that encourages -leaning against bubbles‖ and giving due consideration to alternative tools other than interest rate policy tools.

Targeting Asset Bubbles: Evolution of Policies

Before the Great Recession the policy was not to interfere with increases in asset values, and if any resulting asset bubble crashes led to financial instability, then policies would be enacted to help the recovery. The crash that led to the recent financial crisis changed the mind of many researchers as they more thoroughly investigated the present and the past crises concluding that more attention needs to be paid to financial stability. This involved microprudential policies, meaning policies that would stabilize financial firms, as well as experimentation with macroprudential policies whose purpose is to stabilize a specific sector. By stabilizing a sector, the hope is that no spill over would take place to destabilize the financial system.