Donald L Kohn: Monetary policy and asset prices
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, at "Monetary Policy: A Journey from Theory to Practice", a European Central Bank
Colloquium held in honor of Otmar Issing, Frankfurt, 16 March 2006.
References for this speech can be found on the US Federal Reserve Systems's website.
* * *
I am honored to participate in this tribute to Otmar Issing. I have known and admired Otmar for some
time. It has been a source of great pride that he has considered me a worthy intellectual sparing
partner over the years. From the hiking trails of Jackson Hole to the restaurants of Frankfurt and at
many conferences in between, we have challenged each other to state our assumptions, examine the
evidence, and adjust our conclusions accordingly. I have derived enormous benefit from that
give-andtake--a sentiment, I am sure, that many others in this room share.
I can think of no better way to celebrate the signal contributions of this leading force in the world of
monetary policymaking than to address an issue of great importance to central banks, and one that
has drawn considerable public attention and comment of late--namely, the proper role of asset prices
in the determination of monetary policy. Otmar and I have debated this issue on many occasions, and
these discussions--together with recent research carried out at the European Central Bank, the Bank
for International Settlements, and elsewhere--have been both challenging and stimulating. The
preparation of this talk has afforded me a welcome opportunity to reexamine my thinking on this
subject. So, today, I will review the arguments and the evidence as I see them and draw out the
conclusions to which I am currently led.
At the outset, let me stress that I will be expressing my own opinions, which are not necessarily shared
by my colleagues on the Federal Open Market Committee.1
Two strategies for dealing with market bubbles
Most fluctuations in stock prices, real estate values, and other asset prices pose no particular
challenge to central banks, as they are just some of the usual factors influencing the outlook for real
activity and inflation. But many argue that pronounced booms and busts in asset markets are another
matter, especially if actual valuations appear to be misaligned with fundamentals. What should a
central bank do when it suspects it faces a major speculative event--one that might be large enough to
threaten economic stability when it unwinds? To help frame the discussion, I will focus on two different
strategies that have been proposed for dealing with market bubbles.
The first approach--which I will label the conventional strategy--calls for central banks to focus
exclusively on the stability of prices and economic activity over the next several years. Under this
policy, a central bank responds to stock prices, home values, and other asset prices only insofar as
they have implications for future output and inflation over the medium term. Importantly, the strategy
eschews any attempt to influence the speculative component of asset prices, treating any perceived
mis-pricing as, rightly or wrongly, an essentially exogenous process. Following this strategy does not
imply that policymakers ignore the expected future evolution of speculative activity. If policymakers
suspect that a bubble is likely, say, to expand for a time before collapsing, the implications of that
possibility for future output and inflation need to be folded into their deliberations. Practically speaking,
however, I view our ability to act on such suspicions as limited given how little we know about the
dynamics of speculative episodes.
Despite its approach to perceived speculative activity, the conventional strategy does recognize that
monetary policy has an important influence on asset prices--indeed, this influence is at the heart of the
transmission of policy decisions to real activity and inflation. It occurs through standard arbitrage
channels, such as the link between interest rates and the discount factor used to value expected
future earnings.
The second strategy, by comparison, is more activist and attempts to damp speculative activity
directly. It was described at length in "Asset Price Bubbles and Monetary Policy," an article published
by the ECB last year. I quote from the article: "This approach amounts to a cautious policy of 'leaning
against the wind' of an incipient bubble. The central bank would adopt a somewhat tighter policy
stance in the face of an inflating asset market than it would otherwise allow if confronted with a similar
macroeconomic outlook under more normal market conditions. . . . It would thus possibly tolerate a
certain deviation from its price stability objective in the shorter term in exchange for enhanced
prospects of preserving price and economic stability in the future."2 I am labeling this second approach
extra action, as it calls for steps that would not be taken in ordinary circumstances.3
Compared with the first approach, the extra-action strategy responds to a perceived speculative boom
with tighter monetary policy--and thus lower output and inflation in the near term--with the expectation
of significantly mitigating the potential fallout from a possible future bursting of the bubble. Thus, the
strategy seeks to trade off the near-certainty of worse macroeconomic performance today for the
chance of disproportionally better performance in the future, on the theory that the repercussions of a
major market correction could be highly nonlinear. But the extra-action proposal is by no means a bold
call for central banks to prick market bubbles. As the ECB article stresses, such an attempt would be
extremely dangerous given the risk that a concerted effort at stamping out a speculative boom would
lead to outsized interest rate hikes and recession. Rather, the extra-action strategy is intended only to
provide some limited insurance against the possibility of highly adverse events occurring down the
road.
Common ground
I will be talking at length about the differences between the two strategies, but I must stress up front
how much they have in common. Both policies aim to achieve the same general objectives of
monetary policy, using the same broad analytic framework. Most central banks, I believe, share these
basic features of monetary policymaking, notwithstanding important differences in their official
mandates and the nature of their economies.
At the risk of considerable oversimplification, policymakers can be described as seeking to set policy
over time so as to minimize the present value of future deviations of output from potential and inflation
from a desired level. Of course, we may not be prepared to write down a specific loss function and
say, "There, that's what I'm minimizing." But our deliberative processes and our actions seem broadly
consistent with that characterization of the general problem. This statement is true whether our
institutions have a specific mandate to keep inflation low and stable and output close to potential, as in
the United States, or whether our mandate is defined primarily in terms of stabilizing inflation, as in the
euro area. Stabilizing output complements maintaining price stability in the medium to long run, and
often in the short run as well.
We also can agree that asset prices play critical and complicated roles in determining real activity and
inflation--roles that may be changing over time because an increasing share of wealth is
marketdetermined and easily liquified. Movements in stock prices and real estate values affect household
wealth and thus consumer spending. Changes in bond prices, stock prices, and exchange rates imply
movements in the cost of capital and relative prices that influence investment and foreign trade;
exchange rate movements also directly affect the prices of goods and services. Finally, asset prices
can affect the value of collateral and thus the provision of credit, thereby influencing aggregate
spending. In cases of sharply falling market valuations, these adverse credit-channel effects may even
be exacerbated by the deteriorating health of banks and other financial institutions. In sum, asset
prices influence the economy in complex and subtle ways over potentially extended periods of time.
Finally, I think it fair to say that most central banks, faced with only a limited understanding of asset
prices and their interactions with the full economy, engage in a form of risk management when dealing
with market booms and busts. In part, they do this because any particular policy under consideration is
never associated with a single forecast for the future paths of output and inflation but, instead, with a
large set of possible scenarios with differing odds of coming to pass. While no one uses formal
Bayesian methods to solve this difficult problem, I think most policymakers do engage in at least an
informal weighing of the various possibilities and their implications when setting policy.
Three conditions for extra action to lead to better outcomes
Now let me turn from areas of agreement to more contentious issues, ones that have a strong bearing
on the relative merits of the two strategies. As the ECB article notes, extra action is often seen as a
type of insurance. And as with any insurance policy, before you buy you have to ask whether the
expected benefits outweigh the costs. As I see it, extra action pays only if three tough conditions are
met. First, policymakers must be able to identify bubbles in a timely fashion with reasonable
confidence. Second, there must be a fairly high probability that a modestly tighter policy will help to
check the further expansion of speculative activity. And finally, the expected improvement in future
economic performance that would result from a less expansive bubble must be sizable. You may be
thinking that, in stating the three conditions, I have slanted the case with such phrases as "reasonable
confidence" and "fairly high probability." But stick with me, and I hope to persuade you that these
probabilistic qualifiers are needed to judge the merits of extra action.
For the moment, let me set aside the first condition and assume that central banks can distinguish an
emerging bubble from improving fundamentals at an early stage. What about the other two conditions?
Should we presume that a limited application of restrictive policy would materially restrain the
speculative boom and make its eventual unwinding less disruptive for the overall economy?
Consider the U.S. stock market boom of the mid-to-late 1990s. The boom was fueled by a sustained
acceleration of productivity and an accompanying rise in corporate profits--fundamental changes that
justified a major rise in equity prices. How high those prices should have risen was difficult to judge in
real time because no one, not investors or central bankers, could be sure how fast profits would grow
in the future. In the event, share prices increased more than was justified by improved fundamentals.
But overly optimistic expectations for long-run earnings growth were not being driven by easy money,
and I see no reason to believe that an extra 50 or even 100 basis points on the funds rate would have
had much of a damping effect on investor beliefs in the potential profitability of emerging technologies.
At present, we just do not have any empirical evidence of a link between interest rates and corporate
equity valuation errors, as opposed to standard arbitrage effects.
In general, we have a very poor understanding of the forces driving speculative bubbles and the role
played by monetary policy. In fact, we cannot rule out perverse effects.4 Again, consider the U.S.
experience of the late 1990s. When the FOMC tightened in 1999 and early 2000, the trajectory of
stock prices actually steepened, and equity premiums fell--perhaps because investors became more
confident that good macroeconomic performance would be sustained. Since mid-2004, we have seen
a marked decline in bond-term premiums, even as the funds rate has risen steadily. These episodes
illustrate that risk premiums often move in mysterious ways, and we should not count on the ability of
monetary policy to nudge them in the intended direction.
Perhaps housing markets differ from equity and bond markets. For example, homeowners, who may
have a less sophisticated understanding of the economy than professional investors, might mistakenly
view a one-time rise in home prices--resulting, say, from a decline in interest rates--as evidence of a
more persistent upward trend. If so, a monetary easing directed at stabilizing output and inflation
might, conceivably, drive up real estate values by more than fundamentals alone would merit. Still, you
would expect any mis-pricing from these sources to be reversed over time as interest rates returned to
normal. In any event, empirical evidence on this issue is scanty. More broadly, further research into
the causal connections, if any, between monetary policy and bubbles would seem to be needed before
we would know enough to be able to act on such linkages with much confidence.5
However, let us suppose a situation arises in which we are convinced that tighter policy would check
the future expansion of an emerging speculative bubble. Even then, with the second condition now
met, the third condition might not hold: The expected improvement in future macroeconomic
performance from moderating the bubble's expansion may not be enough to more than offset the
upfront costs of extra action. To explain this statement, I note again that extra action with near-certainty
weakens the economy and reduces inflation before the bubble bursts in exchange for the chance of
better macroeconomic performance in the future.
Admittedly, if the worst-outcome scenario associated with an unchecked bubble is judged sufficiently
dire and if the scenario is not seen as too improbable, then a risk-averse policymaker might regard the
expected return from extra action insurance as worth its upfront cost. However, our confidence in such
an assessment would seem to hinge on believing that the effects of market corrections could be
markedly nonlinear. Proponents of extra action often cite an increased risk of severe financial distress
as a potential source of such effects. However, without the onset of deflation, how large is this risk? In
recent history, the health of the U.S. financial system remained solid after the collapse of the high-tech
boom, despite the bankruptcy of dozens of telecom and dot-com firms, the loss of more than $8 trillion
in stock market wealth, and stress in the nonfinancial corporate sector. Moreover, the financial sectors
of most other developed economies also weathered the worldwide drop in corporate equity values
fairly well.
Of course, the nonlinear risks associated with a collapsing bubble may depend on the initial health of
the financial system, and under some circumstances we could be worried about the potential for
significant financial distress to accompany the bursting of a bubble, should that bubble expand further.
Even in such cases, however, I wonder whether good prudential supervision in advance and prompt
action to clean up any lingering structural problems afterward would not be better ways to deal with
this possibility. Certainly, closer oversight of banking systems during the 1980s, including the United
States, would have left many economies in a stronger position during the early 1990s. This lesson has
been absorbed by supervisory authorities around the world, as evidenced by our successful efforts to
strengthen bank capital and our financial systems.
I do agree that market corrections can have profoundly adverse consequences if they lead to
deflation, as illustrated by the United States after the 1929 stock market crash and the more recent
experience of Japan. But it does not follow that conventional monetary policy cannot adequately deal
with the threat of deflation by expeditiously mopping up after the bubble collapses. In Japan, deflation
could probably have been avoided if the initial monetary response to the slump in real estate and
stock market values had been more aggressive; in addition, macroeconomic performance would have
been better if the government had dealt more promptly with the structural problems of the banking
sector.6 As for the Great Depression, the Federal Reserve actually worsened the situation by allowing
the money supply to contract sharply in 1930 and 1931, after unwisely attempting to prick the stock
market bubble in the first place. Rather than demonstrating the need for preemptive extra action to
restrain emerging bubbles, these examples are object lessons concerning the wisdom of central
banks' easing promptly and aggressively following market slumps when inflation is already low, so as
to head off the threat posed by the zero lower bound. By doing so, policymakers should be able to
avoid the severe nonlinear dynamics of deflation.
Proponents of extra action often argue that it should reduce the risk of hitting the zero bound, but we
should recognize that under some circumstances extra action may actually exacerbate the problem.
To see this, suppose that a speculative bubble has emerged and that a central bank, operating under
a conventional strategy, has raised interest rates to keep the projected output gap closed and
expected inflation at its desired level before the bubble bursts. Now the central bank contemplates
taking extra action. In a low-inflation environment, such a step would be a bad idea if, after averaging
across all the possible outcomes weighted by their likelihoods, the predicted moderation in the bubble
from tighter policy is small. In this case, the expected weakening in real activity after the bubble bursts
would be only marginally less severe under extra action, but inflation would be substantially lower
because the extra action policy would have generated persistent economic slack beforehand. With
inflation having already started out at a low level, such a decline would be extremely dangerous
because the zero bound would now be much more likely to constrain monetary policy after the bubble
bursts. Under these conditions, extra action would therefore worsen expected economic performance,
not improve it.
Another purported benefit of extra action is that, by raising the cost of capital to firms and households,
it helps reduce overinvestment fostered during speculative booms, thereby making it easier for the
economy to recover after the bubble collapses. However, we should be careful not to exaggerate the
macroeconomic importance of such capital mis-allocation. True, the U.S. high-tech boom led to
overinvestment in some sectors, wasting resources and creating lingering difficulties while capital
overhangs were eliminated. But it is hard to see much of a cost in terms of diminished aggregate
productivity, given the robust growth of output per hour over the past few years.
Furthermore, even if tighter monetary policy would have damped the enthusiasm for dot-com firms in
the late 1990s, higher interest rates would have also led to less housing and less business investment
outside the high-tech sector, where valuations were not obviously out of line with fundamentals. Thus,
mitigating capital misallocation in one sector would have created capital misallocations elsewhere,
making the assessment of the net gain from extra action difficult. And, as I have been pointing out,
extra action would have idled some capital entirely for a time as economic activity fell short of its level
consistent with stable inflation.
Now I would like to return to the first condition, the one I sidestepped a few minutes ago--the question
of identifying market bubbles in a timely fashion. The ECB article stressed that such identification is a
tricky proposition because not all the fundamental factors driving asset prices are directly observable,
as the productivity acceleration and stock market boom of the 1990s illustrate. For this reason, any
judgment by a central bank that stocks or homes are overpriced is inherently highly uncertain.
Under extra action, mistakenly identifying a bubble has significant costs. By acting to mitigate a
nonexistent problem, the central bank reduces real economic activity and inflation below their desired
levels to no purpose. Admittedly, policymakers, once they recognize their mistake, would presumably
want the economy to run hotter for a time to restore the previous rate of inflation and would thereby
make up for the initial output losses. But coming to the realization that the original assessment was
mistaken and that asset prices were in line with fundamentals is likely to take some time. And the
mistaken call would have reduced welfare by needlessly inducing fluctuations in the macroeconomy.
Timing is also an issue. Let us suppose that the evidence is so compelling that policymakers become
fairly confident that valuations are excessively rich. Unfortunately, I suspect that this call would often
come so late in the day that, given the lags in the monetary transmission mechanism and uncertainty
about the duration of bubbles, raising interest rates might actually risk exacerbating instability. The
market correction could occur with policy in a tighter position but before extra action had enough time
to materially influence speculative activity.
Notwithstanding the controversial aspects of identifying bubbles, policymakers may still want to warn
the public about the possibility of asset price misalignments when the evidence merits. Such talk might
do some good by prompting investors to stop and rethink their assumptions. And talk by itself should
not do much lasting harm even if valuations turn out to be justified--provided, however, that words are
not seen as precursors to action under circumstances in which conventional policy would still be the
best approach.
To wrap up this critique, I summarize as follows: If we can identify bubbles quickly and accurately, are
reasonably confident that tighter policy would materially check their expansion, and believe that severe
market corrections have significant non-linear adverse effects on the economy, then extra action may
well be merited. But if even one of these tough conditions is not met, then extra action would be more
likely to lead to worse macroeconomic performance over time than that achievable with conventional
policies that deal expeditiously with the effects of the unwinding of the bubbles when they occur. For
my part, I am dubious that any central banker knows enough about the economy to overcome these
hurdles. However, I would not want to rule out the possibility that in some circumstances, or perhaps
at some point in the future when our understanding of asset markets and the economy has increased,
such a course of action would be appropriate.
Asymmetries and moral hazard
Proponents of extra action have their own bones to pick with the conventional strategy, especially as it
relates to the alleged asymmetric nature of the policy's response to asset market booms and busts. In
particular, the claim is often made that, based on the FOMC's actions over the past twenty years, the
Fed actively works to support the economy in an event of a sharp decline in asset markets but does
little or nothing to restrain markets when prices are rising, thereby creating moral hazard problems.
This argument strikes me as a misreading of history. U.S. monetary policy has responded
symmetrically to the implications of asset-price movements for actual and projected developments in
output and inflation, consistent with its mandate. The most convincing evidence for this statement can
be found in the results: Interest rates have been consistent with underlying inflation remaining
reasonably stable for some time now, accompanied by relatively mild fluctuations in real activity.7
Conventional policy as practiced by the Federal Reserve has not insulated investors from downside
risk. Whatever might have once been thought about the existence of a "Greenspan put," stock market
investors could not have endured the experience of the last five years in the United States and
concluded that they were hedged on the downside by asymmetric monetary policy. Nor, for that
matter, should they have concluded that the Federal Reserve does not act on the upside: If asset
prices had been more closely aligned with fundamentals in the late 1990s, our policy would almost
certainly have been easier, all else equal, because aggregate demand would have been weaker and
hence inflation pressures even more muted than they were. The same considerations apply to
homeowners: All else being equal, interest rates are higher now than they would be were real estate
valuations less lofty; and if real estate prices begin to erode, homeowners should not expect to see all
the gains of recent years preserved by monetary policy actions. Our actions will continue to be keyed
to macroeconomic stability, not the stability of asset prices themselves.
Ironically, one can argue that extra action may pose a more significant risk of moral hazard. It is one
thing for policymakers to raise questions about the relationship of asset prices to fundamentals and
another for a central bank to take action to influence valuations in the direction of some "appropriate"
level. How does this strategy play out if a central bank takes extra action and speculative activity
continues unabated or even intensifies? Do policymakers raise rates even further above levels
consistent with conventional policy and, if so, at what consequences for the economy? And what is the
risk that, in taking such steps, a central bank would be seen by investors as taking on partial
responsibility for asset prices? If so, would the pressure on central banks to support asset prices in
market downturns increase?
Conclusion
My remarks today have been intended as a salute to Otmar and to all the valuable contributions he
has made over the years to my thinking and to that of policymakers around the world. Otmar, you have
taught me much about intellectual rigor in support of central bank contributions to economic
welfare-and about friendship. Weighing the relative merits of extra action and conventional policy is not easy
and requires a nuanced interpretation of the arguments and the evidence, as well as some hard
thinking. Otmar and his colleagues have done this in advancing the case for extra action, and by so
doing they have given me a good intellectual workout--and Otmar, I thank you for that. I hope my
response has provided a good workout in return. I look forward to continuing the debate and especially
the friendship for many years to come.