Don Kohn gave a speech in Frankfurt last week at the German Bundesbank on the "Success and Failure of Monetary Policy since the 1950s." Kohn has worked at the Fed for the entirety of Greenspan's tenure, and he seems to have absorbed a lot of Greenspan's views. However, in the first part of his speech (covered in an earlier post), Kohn seems to be distancing himself from Greenspan's opposition to inflation targeting. In the second half though, Kohn returns to the fold and whole-heartedly endorses the Greenspan view of asset price bubbles, which I think of as the "Mopping Up" approach:
1. The Fed can't predict Asset Bubbles,
2. Even if we could identify a bubble, the Fed can't stop it without damaging other parts of the economy,
3. After a bubble bursts the Fed can cut rates aggressively to limit the damage to the broader economy.
The second of David's open issues--whether central banks should lean against possible asset price bubbles--was the key topic in my discussion here eighteen months ago, at Otmar's festschrift. My answer then is my answer now. A central bank should focus on the outlook for the macroeconomy and generally relegate asset prices to the subordinate role of inputs to the forecast process. I view this as the simple application of humility that David and I find so admirable. Although economic theory provides no settled answers to any topic, its predictions are especially imprecise with regard to asset pricing, which has two implications for central bankers. First, little confidence can be attached to the determination that an asset bubble exists except in the most extreme of circumstances. Second, even less confidence can be attached to predictions of the effects of policy on asset prices, and in particular on any speculative element in those prices. Moreover, monetary policy actions addressed at a perceived bubble in one sector may have undesirable effects on other asset prices and the economy more generally.
As a result, my preferred policy framework remains three pronged: First, assign the single instrument of monetary policy to its macroeconomic objective; second, rely on regulation to erect a resilient financial structure; and, third, in the event that market judgments prove to be wrong and financial prices adjust sharply, apply the tool of monetary policy to the macroeconomic task at hand [Shivers: i.e. cut rates]. That task is not always easily captured by simple statistical regularities. Relationships between financial markets and economic results are complex and nonlinear, especially when markets are not behaving normally. When investors are ebullient, their expectations of outsized capital gains can feed on themselves and back on the economy. On the way down, investors' loss of confidence, a reduction in credit availability, and a tightening of terms and conditions for credit have the potential to have pronounced effects on activity and inflation.
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