Saturday, May 9, 2009

Analysis of a monetary policy disaster

Martin Wolf has an excellent obituary of "inflation targetting", which had emerged as the "holy grail of fiat (or man-made) money" over the past three decades.

Frederic Mishkin of Columbia University had argued that inflation targeting is an "information-inclusive strategy for the conduct of monetary policy", which allowed for "all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation". Arguing against proactively pricking asset price bubbles, Prof Mishkin wrote that "it is highly presumptuous to think that government officials, even if they are central bankers, know better than private markets what the asset prices should be".

From William McChesney Martin, who claimed that it was the role of Central Bankers role to "remove the punch bowl as the party gets going", to "serial bubble blower" Alan Greenspan and his reluctance to prick asset bubbles, to the present realization that asset price bubbles can have devastating consequences and should be detected and deflated, the wheel has come the full circle.

The "Great Moderation" - the substantial decline in macroeconomic volatility over the past twenty years - had lulled Central Banks into believing that effective monetary policy could smooth over the business cycle and help tide over any economic downturns. Carried away by the euphoria, even the demure Ben Bernanke allowed himself a pat on the back, claiming that "some of the effects of improved monetary policies may have been misidentified as exogenous changes in economic structure or in the distribution of economic shocks... I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature."

Alan Greenspan had consistently argued that bubbles are hard to identify before they burst and pricking them is even harder without wrecking the economy. He felt that Central banks should act only if bubbles threaten price stability else, they should wait and clean up after they burst. The shallow recession that followed the tech-stock boom of the late 1990s seemed to vindicate them. Martin Wolf points to three critiques of this approach to central banking.

First, the Fed's deviation from the Taylor Rule, which relates interest rates to inflation and output, in keeping interest rates too low for too long in early 2000s caused the credit bubble and housing boom. Further, the low rates also had a cascading effect on central banks across the world, thereby generating bubbles in many countries.

Second, the sub-prime mortgage triggered current financial market crisis is a timely reminder about the dangers associated with asset price bubbles and the need for Central Banks to deflate such bubbles before they balloon out of control. Experience from across the world shows that "when nominal asset prices and associated credit stocks go out of line with nominal income and prices of goods and services, one of two things is likely to happen - asset prices collapse, which threatens mass bankruptcy, depression and deflation; or prices of goods and services are pushed up to the level consistent with high asset prices, in which case there is inflation."

Finally, the economists in the 'Austrian' tradition argue it was a mistake to set interest rates below the "natural rate", thereby generate explosive growth of unsound credit and create conditions for misallocation of resources. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

About clearing up the mess from this loose monetary policy and designing a new approach to monetary policy, Wolf writes,

"On the former, we have three alternatives - liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard.

On the latter, the choice, in the short term, is certainly going to be "inflation targeting plus". 'Out' is likely to be the 'risk management' approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. 'In' is likely to be 'leaning against the wind' whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical 'macro-prudential' approach to capital requirements in systemically significant financial institutions."

In other words, the way forward for central bankers is to detect asset price bubbles and then taking appropriate action to deflate them before they blow over. Macro-prudential approach to financial market regulation can help identify systemic risks as they build up. Further, I have already blogged about how models, Markov regime-switching analysis, can detect advance signs of market turbulence emerging. The challenge will still remain to calibrate the monetary policy actions to deflate the asset price bubbles in such a manner as to minimize its impact on economic growth. Taylor Rule, of course is only the most popular model for calibrating monetary policy in such circumstances.

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