Should the central banks kill the bull markets?

Gavyn Davies On asset price inflation and why the FED is starting to worry
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The Independent Online
NOW that central bankers have been granted omniscient status in many parts of the world, they are of course expected by the public to do the impossible. Cutting through the impenetrable mist which sadly still surrounds these institutions, central bankers can essentially do one thing, and one thing only - they can either raise or lower the short-term rate of interest. Changing the short rate may or may not have the desired effect on long bond yields, equity prices and property prices in the rest of the economy. It may or may not impact on private spending, unemployment and inflation in the anticipated manner. It may result in the exchange rate either rising or falling. At best, with only one policy instrument at their disposal, central banks can achieve only one of these objectives at any given time and, if they attempt to aim their single instrument at more than one objective, they are quite likely to run into severe trouble.

We have seen a recent instance of this in the UK, where the Bank of England has been asked simultaneously to protect the manufacturing sector by holding down the exchange rate, while also acting to dampen inflation pressures in the service sector. It would be serendipitous if both of these objectives could be accomplished simply by varying the short-term interest rate - and so far this has not proven to be the case. (It would be far better, incidentally, if the Bank would spell this out in no uncertain terms to the public, so that it is not henceforth expected to perform the impossible.)

A similar phenomenon is beginning to worry the new European Central Bank. If the ECB manages to achieve price stability for the entire euro area, some countries will probably experience high inflation, while others suffer outright deflation. Obviously, help will be needed from national fiscal policy in order to iron out these discrepancies, and once again the ECB should make this crystal clear to the public before the inevitable disappointment sets in.

A third comparable area concerns US share prices, which have increased almost two-and-a-half fold in the past three years. Many observers convinced themselves years ago that they have been observing symptoms of what Alan Greenspan calls "irrational exuberance". Among many others, The Economist has urged the Federal Reserve to tighten US monetary policy simply in order to control this surge in asset prices, even though consumer price inflation is very docile at below 2 per cent per annum. This of course immediately raises the issue of whether a central bank ought to be concerned with the stability of asset prices (shares, property etc) as well as that of the prices of goods and services, which are the only prices which show up in official inflation indices.

Most ordinary voters would, no doubt, be surprised at the suggestion that the central bank should assume such a responsibility. After all, most people seem to regard rising equity and house prices as a good thing, even though many of them will be net buyers of such assets in the future, and are therefore outright losers when prices go up today. More generally, while a rapid increase in consumer prices should almost always be considered a "bad thing", this is not true of asset prices, which might increase for sound fundamental reasons such as a permanent decline in interest rates or an increase in the rate of return on capital. Both have quite obviously happened in the US during the 1990s. It is not clear why the public interest should be served by seeking to control such phenomena.

For these and other reasons, central banks have never been persuaded that they should take action solely to prevent increases in asset prices. Certainly, in a case where rising asset prices are seen as a leading indicator of future increases in consumer price inflation - perhaps working through higher consumer spending in response to an improvement in household wealth - then it is obvious that central bank action is required. But it is much trickier to decide whether asset price inflation, in and of itself, should be a cause for central bank action, when consumer price inflation seems set to remain low and stable.

The reason that this even arises as an issue is that some of the most disruptive bouts of inflation in the past decade, with the most severe consequences for output and employment, have come in asset prices, not consumer prices. Obvious examples are Japan in the late 1980s, Britain and Scandinavia in the early 1990s, and the Asian tigers in the past 12 months. In each case, an asset price bubble has been encouraged by lax liquidity conditions, only for this bubble suddenly to burst, taking the banking sector and the entire economy down with it. Those who are worried about the current "over-valuation" of Wall Street believe that the same may be happening in America today.

It is probable that, if the Federal Reserve could be persuaded that a liquidity-driven asset price bubble were indeed developing in the US today, then there would be a presumption in favour of raising interest rates immediately, even though consumer price pressures are conspicuous by their absence. In fact, Alan Greenspan himself argued in his "irrational exuberance" speech in December 1996 that "evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy". According to Greenspan, the Federal Reserve accepts a responsibility to iron out asset price bubbles that "might impair the real economy".

But the problem here is deciding when a bubble really is a bubble. Typically, in any period of rapidly rising share prices, there are series of new factors which can be adduced to explain the bull market. Sometimes it turns out that these factors are fundamentally well based, in which case the bull market proves sustainable. Other times, they turn out to be figments of market "hype", and the bubble bursts, usually in a very painful manner. The difficult part is spotting the difference between these two situations while there is still time to take action. At present, it is far from clear that the US stock market is experiencing a bubble. As the accompanying graph (from Bill Dudley of Goldman Sachs) demonstrates, the rise in equities relative to bonds, or the decline in the equity risk premium, has happened primarily because equities are genuinely less risky in a low inflation environment. No sign of an equity bubble here.

Other valuation techniques give a more worrying answer, and there is no doubt from a series of recent speeches that the Federal Reserve is becoming concerned that US equities are in overvalued territory. But it is another matter to be certain enough that this is the case to raise interest rates when there is no other cause to tighten policy. The Fed's view appears to be that, in the transparent capital markets of the US, and with the banking sector looking robust and healthy, asset price inflation should only be a concern of the central bank if it expected to trigger consumer price inflation down the road. So far, they have not quite reached that conclusion, so interest rates are still on hold.

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