I worry increasingly that history will not treat the recent record of central banking kindly. Inflation may well have been conquered – a conclusion financial markets are actively debating again – but that was yesterday’s battle.
Over the past six years, monetary authorities have turned the liquidity spigot wide open. This has given rise to an endless string of asset bubbles – from equities to bonds to property to risky assets (emerging markets and high-yield credit) to commodities. Central banks have ducked responsibility for this state of affairs. That could end up being a policy blunder of monumental proportions. A new approach to monetary policy is urgently needed.
Modern-day central banking was born out of the Great Inflation of the 1970s. Led by Fed Chairman Paul Volcker, monetary authorities became tough and disciplined in their efforts to break the back of a deeply entrenched inflationary mindset. Price stability became the sine qua non of macro stabilization policy. Nothing else really mattered.
Without inflation, it was argued, economies could realize extraordinary efficiencies that would enhance resource allocation and maximize returns for the owners of capital and providers of labor (see, for example, Alan Greenspan’s 3 January 2004 speech, “Risk and Uncertainty in Monetary Policy”). Who could ask for more?
The subsequent disinflation was a major victory for central banking. It was also a major victory for the “monetarists” who argued that inflation was everywhere and always a monetary phenomenon (see Milton Friedman, A Theoretical Framework for Monetary Analysis, 1971). In retrospect, central banking’s finest hour came in the early days of this struggle – in the immediate aftermath of the wrenching monetary tightenings that were required to break the vicious circle of the inflationary spiral.
Unfortunately, the authorities have been much less successful in “managing the peace” – steering post-inflation economies toward the hallowed ground of price stability. By focusing solely on the inflation battle, there is now risk of losing a much bigger war. That’s what the profusion of asset bubbles is telling us, in my view. The great triumph of central banking rings increasingly hollow in today’s bubble-prone environment.
What happened along the way? For starters, circumstances changed – in particular, circumstances that a one-dimensional monetary policy framework was ill-equipped to handle. Two developments are key in this regard – IT-enabled productivity growth and globalization. Both of these structural developments had – and continue to have – powerful disinflationary consequences.
Fixated on CPI-based targeting – or some variant thereof – central banks missed the trees for the forest. Focused on formulistic linkages between policy instruments and inflation, they failed to allow for the structural pressures that reinforced an increasingly powerful disinflation.
America’s Federal Reserve was different. Under the leadership of Alan Greenspan, the Fed was quick to jump on the productivity story. But its reaction may well have sown the seeds for today’s problems. Ultimately, the Fed took the productivity story to mean that the US economy could run hotter without suffering inflationary consequences. In response, the Fed all but abandoned economic growth as an “intermediate target” in its quest for price stability – effectively ignoring a signal that normally would have led to a monetary tightening in a high-growth climate.
By embracing a new approach to monetary policy, and in taking on the unaccustomed role as a “cheerleader” for the IT-enabled US economy, the Greenspan-led Fed not only stayed easier than might have otherwise been the case but also sent a powerful “buy” signal to equity market participants.
The rest is history – and a potentially painful one at that. By consciously ignoring the perils of a mounting asset bubble – a stunning reversal, of course, from Alan Greenspan’s original warning of “irrational exuberance” in the stock market in December 1996 – the Fed became entrapped in the dreaded multi-bubble syndrome.
Stressing that it had learned the lessons of Japan, the US central bank was aggressive in easing in the aftermath of the bursting of the equity bubble. A new Governor by the name of Ben Bernanke led the charge at the time in arguing that the US central bank should use every means possible to avoid an unwelcome post-bubble deflation – including, if necessary, “unconventional” measures aimed at targeting the yield curve, providing subsidized bank credit, and even pegging the dollar (see his 21 November 2002 speech, “Deflation: Making Sure “It” Doesn’t Happen Here”).
With inflation low – and the risk of deflation actually rising at the time – the price-targeting Fed had no compunction about turning the liquidity spigot wide open. And so the miracle drug that was used as the cure for the first bubble created a dangerous addiction – systemic risk, in financial market parlance – that has fostered a string of asset bubbles. Unfortunately, that addiction has yet to be broken.
What can be done? In technical terms, the problem boils down to one of coping with asymmetrical risks at low nominal interest rates. The inference here is that the policy rule of the inflation targeter may need to become increasingly flexible as an economy approaches price stability. When inflation is low and a price-targeting central bank pushes nominal interest rates down to unusually low levels, there are new risks to confront – namely, asset bubbles.
Central banks that let economies “rip” because inflation risks are minimal, are asking for trouble. That doesn’t mean monetary authorities should target asset prices. It does mean, however, that there are times when asset markets need to be taken into consideration in the setting of monetary policy. A low nominal interest rate regime is precisely one of those times.
This is heady stuff in policy circles. It implies that the Fed should have started leaning against the equity bubble in the late 1990s – precisely the intent of Alan Greenspan’s initial concern over irrational exuberance. The same may well be the case today when central banks are faced with the inflationary headwinds imparted by globalization.
In the end, there must be more to monetary policy than a single-mined preoccupation with price stability. Once “zero inflation” is close at hand, the monetary authority needs to become more nimble and broaden out its goals. In a low-inflation climate, monetary authorities should be especially wary of fostering excess liquidity that plays to the asymmetrical risks of asset bubbles; instead, policy should become predisposed more toward tightening than accommodation.
This is where the debate currently rages in central banking circles. Obviously, the Bank of Japan has learned the most painful lesson of all. The Bank of England and the Reserve Bank of Australia have both tightened in response to emerging property bubbles. Otmar Issing of the European Central Bank has argued that developments in asset markets may well present modern-day central banking with its greatest challenge (see Issing’s op-ed essay in the 18 February 2004 Wall Street Journal, “Money and Credit”).
But it is the Bank for International Settlements – the bank for central banks – that has really taken intellectual leadership in this debate. A recent paper by William White, head of economic research at the BIS, makes a strong case that central banks can avoid the perils of asset bubbles by allowing for greater flexibility of monetary policy in pursuit of price stability (see “Is Price Stability Enough?” BIS Working Paper No. 205, April 2006).
Other BIS researchers have recently stressed the unusual restraint that globalization has imparted to inflation (see Claudio Borio and Andrew Filardo, “Globalisation and Inflation: New Cross-Country Evidence on the Global Determinants of Domestic Inflation,” March 2006). In their view, if monetary policy ignores the new structural forces constraining inflation, there is a risk of “undesirable side effects, such as … the build-up of financial imbalances, notably excessive credit and asset price increases that could raise material risks for the economy further down the road.”
By contrast, America’s Federal Reserve is increasingly isolated in arguing that asset markets should be ignored in the setting of monetary policy. In fact, its new chairman is the academic high priest of inflation-targeting – embracing an even tighter rules-based approach than his predecessor. Asset bubbles are, at best, an after-thought in a strict inflation-targeting regime.
Therein lies the potential for a strategic policy blunder: The US central bank has yet to develop an exit strategy from the multi-bubble syndrome that the Fed, in its zeal for inflation targeting, has spawned. Moreover, as one bubble begets another, excess asset appreciation has become a substitute for income-based saving – forcing the US to import surplus saving from abroad in order to sustain economic growth.
And, of course, the only way America can attract that capital is by running a massive current-account deficit. In other words, not only has the Fed’s approach given rise to a seemingly endless string of asset bubbles, but it has also played a major role in fostering global imbalances.
Central banks deserve great credit for waging a successful battle against inflation. To their credit, this war is never over – monetary authorities must always remain alert to the possibilities of a resurgence of inflation. But policy strategies have been surprisingly unprepared to cope with the pitfalls that emerge as economies near the hallowed ground of price stability. Nor have inflation-targeting monetary authorities shown themselves to be adaptable to changing circumstances, such as IT-enabled productivity enhancement and globalization.
To the extent rules-bound central banks operate in a vacuum and fail to appreciate the impact of these powerful structural headwinds, they may be biased toward injecting too much liquidity into the system. The multi-bubble experience of the past six years is a wake-up call for central banks. A new approach to monetary policy is urgently needed.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum