Lorenzo Bini Smaghi: Monetary policy and asset prices
Opening address by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the
European Central Bank, at the University of Freiburg, Freiburg, 14 October 2009.
* * *
Introduction1
It is a great pleasure to take part in this ceremony at the University of Freiburg.
Freiburg has traditionally provided a nurturing environment for economic ideas. Some of
these ideas have exerted a strong influence on the design of economic systems and
institutions. When Walter Eucken was recommending that monetary policy should be the
responsibility of a central bank committed to price stability and independent from political
pressures, his was a minority view in international academic circles and among most
policymakers. It has since become best practice.
The recent financial crisis has led some observers to question the role of monetary policy, in
particular with respect to its objectives. Is price stability too narrow an objective? Should
monetary policy also be entrusted with the objective of preserving financial stability? After all,
the last two decades have witnessed the coexistence of, on one hand, relatively low and
stable inflation in large parts of the globe and, on the other hand, the dot-com boom and bust
at the turn of the millennium and the financial crisis we are still experiencing. Some have
even argued that a monetary policy too narrowly focussed on price stability might actually
fuel asset price bubbles. These questions, and how they are addressed by the ECB's
monetary policy strategy, will be the focus of my remarks. In this speech I will take a
longerterm perspective, without dwelling on the shorter-term prospects for the course of monetary
policy in the euro area.
Let me state my conclusions up front. The appropriate primary objective of monetary policy is
to maintain price stability over the medium term. Financial stability is best ensured through
instruments other than the policy interest rate and in the context of a broader framework of
macro-prudential supervision. Nevertheless, a central bank should actively monitor asset
prices and credit flows. The evolution in these variables provides timely and useful
information, which helps to better calibrate the course of monetary policy and to avoid the
risk of being "behind the curve".
1. Monetary policy and asset prices: the pre-crisis consensus view
A good starting point for my analysis is a brief summary of the "pre-crisis" consensus view
about the relationship between monetary policy and asset prices. I stress: "pre-crisis". There
is no "post-crisis" consensus view yet. However, recent events have shaken so profoundly
the conventional wisdom prevailing before the crisis that it is unlikely to remain unchanged.
The pre-crisis consensus view was firmly grounded in the dominant new-Keynesian
paradigm for monetary policy analysis, which builds upon models where financial conditions
play at most a very limited role.2 Within that framework, financial market conditions, such as
developments in asset prices or in the quantity of money and credit, do not affect
macroeconomic outcomes, or the transmission of monetary policy. They may reflect, or even
anticipate, underlying economic conditions, but they do not provide any feedback on those
conditions. The pre-crisis consensus view also rested on a presumption that strong asset
price dynamics and misalignments tend to be associated with strong inflationary pressure. As
a result, a central bank responding to inflation would in any case also automatically address
financial imbalances, because financial imbalances would coincide with upward pressure on
inflation.
Starting from these premises, there is clearly no reason for monetary policy to react to
specific financial market developments. Of course, a central bank may want to monitor
financial and monetary developments, which should be factored into the policy process to the
extent that they contain information about the inflation outlook at a specific policy horizon
(usually two years). This also explains the emphasis put by the consensus view on the output
gap as the main determinant of inflation.
The pre-crisis consensus view also relied on three additional reservations against an explicit
monetary policy reaction to financial imbalances.3
First, doubts were expressed about the ability of central banks to identify asset price
misalignments early on and with a sufficient degree of confidence. Central banks do not have
better information than financial markets, and misalignments can only be identified with
certainty with the benefit of hindsight.
Second, questions were posed about the effectiveness of moderate interest rate increases in
curtailing the bubble. A monetary policy tightening of moderate size would not be able to
counterbalance the prospect of large capital gains normally available during a boom in asset
price. And strong policy-rate hikes would not be a viable option either, as they may pose
serious risks to the economy.
Third, it was pointed out that a decisive easing of the monetary policy stance after the
bursting of the bubble would be sufficient to avoid substantial economic damages. The
central bank should simply be ready to intervene aggressively by slashing policy rates after
the collapse of asset prices in order to sustain real economic activity and minimise the
probability of deflation.
2. Risks associated with the pre-crisis consensus view
Let me mention two main risks associated with the pre-crisis consensus view.
2.1 Delayed removal of policy accommodation
The first risk is that the implementation of such an approach might favour a policy of
"tolerance" and "benign neglect" during the boom phase and a policy of excessive
accommodation during the bust phase. When this is compounded with the central bank's
legitimate fear that a premature removal of policy accommodation may weigh negatively on
the (initially still fragile) recovery, exceptional accommodation in terms of low levels of policy
rates may also become exceptional accommodation in terms of the duration of such a policy.
Delaying or diluting the removal of policy accommodation as inflationary pressure associated
with a turn-around of the economic cycle gradually builds up runs the risk of leaving the
central bank behind the curve.
This risk seems to be an intrinsic feature of the asymmetric policy response to the boom and
bust phases of an asset price bubble which characterises the pre-crisis consensus view. The
counter-argument, that the central bank could successfully correct this outcome by simply
raising policy rates later on as inflationary pressures eventually emerge, does not consider
the transmission lags of monetary policy and the role of inflation expectations. A belated
monetary policy response would require much stronger, and thus more painful, action to be
taken at a later stage to regain control of inflation expectations. Indeed, the longer interest
rates are kept at low levels, the greater is the incentive provided to investors to hold long
term assets, possibly leveraging with carry trade, and the greater the capital loss occurring
when rates are eventually raised. The potential future costs often do not receive appropriate
weight in the policy considerations.
Another less obvious outcome of a hesitant and belated removal of policy accommodation is
that it could set in motion a chain of events that will ultimately create new financial
imbalances with potentially high risks for price stability and for the economy as a whole.
Feedback-loop models provide a simple, yet powerful, analytical framework to illustrate some
of the channels that may be at work. Consider the following stylised course of events.
Excessively low policy rates stimulate economic activity and improve non-financial and
financial firms' profitability, providing an initial boost to asset prices. Low interest rates and
expanding activity encourage demand for credit. Lenders become more willing to
accommodate this demand and to charge lower premiums on the basis of the higher value of
collateral associated with higher asset valuations. The greater availability of credit leads to
more assets being bought, thus boosting their price. This sets in motion a self-sustaining
feedback loop. This endogenous cycle can become even stronger if accommodative
monetary policy contributes to a lowering of credit standards applied by lenders and to a
lower perception of risk - as suggested by the risk-taking channel.4 All these effects provide
the main ingredients for an asset price bubble and the building-up of financial imbalances.
When the day of reckoning comes, the loop will work in reverse. The pre-crisis consensus
view requires at that point an extremely accommodative reaction by the central bank.
Undoubtedly, this kind of monetary policy gives the illusory impression that structural
adjustments can be postponed or, worse, are not necessary at all, thus paving the way for a
second boom and bust. I believe that more attention should be paid to the inter-temporal
dimension of this kind of policy. It is aimed at improving the situation in the short run, while
disregarding completely the risks of triggering new imbalances in the future. Ignoring this
inter-temporal dimension may also weigh negatively on the credibility of public institutions. As
the Austrian economist Ludwig von Mises lucidly expressed it: "The individual is always
ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward
for his talent, application, and probity. But reverses of fortune he always charges to other
people, and most of all to the absurdity of social and political institutions. He does not blame
the authorities for having fostered the boom. He reviles them for the inevitable collapse. In
the opinion of the public, more inflation and more credit expansion are the only remedy
against the evils which inflation and credit expansion have brought about."5
The idea that the recent financial crisis can be traced back at least partly to monetary policy
excesses at the global level at the beginning of the decade has found some support in the
empirical literature. For example, John Taylor has argued that, had the Federal Reserve
implemented less expansionary policies over the period 2002-04 and followed a path for
interest rates more in line with established regularities, the US housing boom would have
been smaller than it actually was.6 Other analysts have argued, however, that during the
years preceding the crisis, on the basis of cross-country evidence, there is no clear-cut
association between the stance of monetary policy and house price increases.7 The final
judgement is still pending.
2.2 Readiness to act may prove insufficient
The second risk associated with the pre-crisis consensus view is that, even when a central
bank is ready and willing to act swiftly, this may prove to be insufficient. In particular, the
emphasis which the pre-crisis consensus view puts on the output gap and on the inflation
forecast at a given horizon may prevent the central bank from identifying the right signals for
the appropriate timing of policy actions.
There is extensive literature analysing the challenges for the conduct of monetary policy
arising from excessive emphasis on the output gap, i.e. the difference between the level of
output and its potential, estimated under the assumption of full utilisation of resources.
Realtime estimates of potential output tend to be quite inaccurate.8 The extent of the revisions in
the measurement of the output gap is so large that often the picture of the state of the
economy provided by this statistic at a particular date is turned upside down subsequently.
The revision process lasts for many years, so it can be a long time before we know with
some confidence the sign and magnitude of the output gap at any particular point in time in
the past.
Chart 1 provides a vivid example of this problem. It displays alternative vintages of
outputgap estimates for the United States as calculated by the IMF. Consider, for instance, spring
2005, when the Federal Funds Target Rate was at the relatively low level of 2.75%. The
initial estimate of the output gap was negative at -1.3%. Two years later it was revised
upwards to 0.1%, and four years later, in 2009, it was revised upwards again to positive
territory 1.4%. Interestingly, the latest estimate suggests that the US output gap was never in
negative territory over the last decade, not even between 2001 and 2005.
Large subsequent revisions of the output gap are not confined to specific years, but are a
pervasive feature. Chart 2 shows the actual size of these revisions as estimated by the
OECD and the IMF in spring 2009. The size of revisions and the disparity between the
different sources is striking.
Euro area output gap estimates are also characterised by a large degree of revision, and
there is an equally large disagreement between different sources, as documented in Charts 3
and 4. However, the latest estimates do suggest that the euro area had a negative output
gap in the period 2002-2005.
Overall, the unreliability of measures of the output gap affects the appropriateness of
monetary policy prescriptions that are predicated on such a construct. And, in all likelihood,
output-gap estimates are going to become more unreliable than ever due to the increased
uncertainty and possible time-variation in potential output brought about by the recent
financial crisis.
The unreliability of output-gap measures is not the only reason why a central bank may fail to
take timely action, irrespective of its willingness to act pre-emptively. A too-narrow focus on
inflation forecasts may be equally hazardous.
On one hand, inflationary pressures might remain latent for years owing to compensation by
other forces, especially if the central bank gives strong weight to measures of core inflation.
For instance, globalisation may exert a disinflationary impact on consumer price inflation
through a rising share of imports from low-cost countries. A focus on core inflation may fail to
detect the inflationary pressure associated with an increase in the prices of oil-related items
and non-energy commodities owing to rising demand from the fast growing non-OECD
economies.9
On the other hand, the relationship between financial imbalances and inflation depends
crucially on the forces driving asset prices. Take for example the second half of the 1990s. At
the time the availability of new technologies and the widespread use of the internet were
expected to lift the potential growth of the economy. The possibility that the dream of a "new
economy" could become true was surrounded by high uncertainty. However, it seemed
rational to invest massively in the new technologies so as to be ready to fully reap the
benefits, if (and when) the new era arrived. This over-accumulation of capital can lead to a
rise in labour productivity. Due to stickiness in nominal wages, labour compensation might
lag the pick-up in productivity. Thus, business profits might boom, which in turn might feed
back into a higher rate of investment and even bigger boost in productivity. These
developments may end up in long-lasting subdued inflationary pressure, or even declining
inflation for an extended period of time. Disinflationary pressure is indeed the result found in
a formal analysis of this type of situation made in a recent research paper at the ECB.10 The
paper shows that if the central bank concentrates exclusively on inflation forecasts as a
summary statistic for the state of the economy, it will tend to adopt an accommodative
stance. This occurs because the central bank, expecting a decrease in inflation, will cut the
policy rate to keep inflation on target. This accommodative policy can trigger an asset price
and credit boom that inflates the original economic expansion. Eventually, it may turn out that
the expectations of a new era, which triggered the over-accumulation of capital, do not come
true. The revision of these beliefs can in turn lead to an asset price bust and to recession.
Clearly, the boom and bust would have been much smaller had the central bank followed a
different monetary policy, based on enlarging its information set to include credit
developments.
3. A more explicit role for financial conditions in monetary policy
So far I have discussed the pre-crisis consensus view on monetary policy and asset prices
from a general perspective. The events of the past two years have already generated
farreaching reflections on this issue.11 Let me mention three avenues.
First, the crisis has clearly demonstrated that the economic costs of the unravelling of
imbalances can be overwhelming, notwithstanding extraordinary policy action - involving
both monetary and fiscal policies. Recent empirical research has explored more
systematically the role of monetary policy in shaping the duration and depth of recessions.12
When no distinction is made with regard to the nature of the downturn, expansionary
monetary policy is found to be consistently associated with shorter recessions. However,
when considering recessions that occur in combination with financial crises, monetary policy
does not have a consistent effect on the duration of recessions. These results undermine
confidence in one of the arguments buttressing the pre-crisis consensus view, namely that
monetary policy can forestall the negative effects of the unravelling of financial imbalances.
Second, the crisis has highlighted the fact that asset price misalignments can have different
consequences depending on the specific market in which they arise. It may well be true that,
in periods of booms in asset prices, expected capital gains are so large that interest rate
movements of a standard magnitude would not be sufficient to alter investor decisions. The
origins of the recent financial crisis, however, are not in equity prices, but rather related to
real estate and to the abnormal growth in securitised credit backed by residential or
commercial properties. Leveraged financial intermediaries have also played an important role
in the recent financial crisis.
In this context, recent research has highlighted the fact that even small changes in policy
rates can have non-negligible implications for financial institutions, which tend to
systematically finance illiquid long-term assets through short-term borrowing. Even small
changes in short-term interest rates can affect their profitability, forcing them to close some
leveraged positions and, potentially, to partially correct any financial imbalances fuelled by
such leveraged positions.13
Third, the recent financial crisis has confirmed that a central bank's inability to identify in real
time the precise mechanisms through which financial imbalances evolve and to anticipate the
exact timing of their unwinding does not mean it is unable to identify the build-up of
imbalances. In the run up to the crisis several policy makers did identify the under-pricing of
risk as a major source of concern. In this context, let me mention that recent research -
including research conducted at the ECB - has reviewed more systematically the
implications for monetary policy of a more explicit role for financial factors in macroeconomic
models.14 This stream of research is still under development, but it does account for an
endogenous interaction between macroeconomic conditions and the demand for and supply
of credit.
The main policy implication of this research continues to be that monetary policy should
pursue price stability as a primary objective. At the same time, however, it is acknowledged
that financial imbalances can generate sizable macroeconomic costs at times of crisis, when
they can produce undesirable economic fluctuations. This justifies a very close monitoring of
financial conditions. These new models also show that financial conditions have an impact
on the notion of a natural rate of interest - the theoretical interest rate level which, if
implemented by the central bank, would ensure that price stability is maintained. Of course,
the practical relevance of this notion is limited, since it is extremely hard to estimate it
accurately and robustly. Nevertheless, developments in financial conditions should be taken
into account when making such estimates.
All in all, both the experience of the past two years and recent developments in the literature
appear to support the view that the use of financial indicators in the context of a broader
analysis of monetary and financial conditions in the economy is beneficial.
4. The ECB approach
The ECB strategy acknowledges that financial imbalances and unsustainable asset price
developments do represent threats to price stability when taking a medium-term perspective.
Given that our mandate requires the maintenance of price stability on an ongoing and
continuous basis, rather than at any specific arbitrary horizon, the accumulation of
unsustainable financial imbalances is a reason for concern, even if it only poses a threat to
price stability over the longer term.
At the same time, the ECB strategy can help to identify financial imbalances in the context of
its "monetary analysis", in which monetary and credit aggregates are monitored, together
with a large set of other financial indicators. One aspect of our monetary analysis is the
identification of low-frequency trends in money and credit growth. This medium to long-term
focus is an implicit way to protect against excessive money, credit and asset price growth in
our interest rate decisions. The focus of the ECB monetary analysis on low-frequency trends
is also consistent with the fact that over a long time horizon, price stability and financial
stability complement and reinforce each other. Financial imbalances, leading to excess credit
growth, high leverage, loose credit standards, booming asset prices and under-pricing of risk,
create the conditions for abrupt market corrections, which also endanger the maintenance of
price stability.
Recognising the importance of monitoring developments in money, credit, and asset prices,
does not mean neglecting the difficulties associated with their interpretation, particularly in
periods of rapid financial innovation. Moreover, there is always a risk of reacting
inappropriately to unusual developments, when these are instead in line with fundamentals.
However, most policy decisions are confronted with similar informational problems and
require a difficult evaluation of the statistical evidence.
While monetary and financial conditions are explicitly part of the analysis of the risks to price
stability at the ECB, such policy is not a panacea, nor a certain means to ensure that
financial crises never arise. There are limitations to what monetary policy alone can achieve.
Excessive risk and pro-cyclicality in the financial system can also result from factors other
than sustained credit growth and high leverage. Hence, they require policy actions that can
address the underlying causes of these factors. Supervisory and regulatory instruments are
particularly well suited to preventing excessive risk-taking and the accumulation of financial
imbalances.
In this respect, the creation of the European Systemic Risk Board (ESRB) should contribute
to foster financial stability. The ESRB was proposed following the setting up of the de
Larosière Group in February 2009, and its establishment was agreed by the Ecofin Council in
June 2009. The main tasks of the ESRB will be to monitor the stability of EU financial
system, to issue warnings when the assessment of risks are deemed to be significant, and to
suggest, when appropriate, policy recommendations. Close cooperation with national EU
supervisory authorities and with global institutions (such as the IMF and the Financial
Stability Board) should help this new institution and the central banks represented on the
ESRB to deal with the challenges posed by increasingly interconnected national financial
systems.
Conclusions
Let me conclude. The recent financial crisis has re-opened the debate on the relationship
between monetary policy and asset prices. At the heart of that debate are questions like: Is
price stability too narrow an objective for monetary policy? Should monetary policy "lean
against the wind", in order to avoid asset price bubbles?
I would answer these questions in two ways.
First, a monetary policy which has price stability as its primary objective is a necessary
condition for avoiding asset price bubbles and promoting financial stability. With the benefit of
hindsight, it seems that some of the financial imbalances which built up prior to the crisis
resulted from monetary policies which were not fully in line with the objective of price stability.
Either the policies were also pursuing other goals, such as supporting economic activity and
employment, or they were not focusing on the appropriate indicators of inflationary
pressures, attaching, for instance, too much importance to output gaps and too little to
monetary and credit developments. The first steps to take are to put monetary policy back on
track - so that it focuses primarily on price stability - and to improve the underlying analytical
framework. In particular, it's essential to include monetary and financial variables in the
information available to central banks. They can provide the signal that the monetary policy
stance needs to be tighter well before the business cycle reaches its peak, in order to ensure
price stability over the medium term.
Second, a monetary policy which is appropriate for price stability might not suffice to ensure
financial stability. Indeed, given that asset prices react more rapidly than other prices, they
may overshoot their long term equilibrium value and have undesirable effects on the financial
system. If this were to happen, should monetary policy react, even if price stability is not at
risk? In other words, should interest rates be raised even if, taking into account all possible
indicators, price stability is not endangered but there are risks of an asset price bubble
building up?
I personally think that a case has not yet been made for such a course of action. It would
imply that monetary policy follows two objectives with only one instrument, i.e. the policy
interest rate. The central bank also has at its disposal the operational framework through
which it injects liquidity into the system. Under certain circumstances such instruments can
be used to foster financial stability, as has been done recently. When financial turbulence
occurred, a modification of certain features of the main refinancing operations, for instance,
through fixed-rate tender procedures with full allotment or by enlarging the collateral basis,
helped to counteract financial instability. However, such action may not be very effective in
symmetrical situations, in trying to counteract asset price bubbles. Evidently, other
instruments are needed and they belong more to the realm of macro prudential supervision.
Unless central banks are explicitly equipped with the appropriate macro-prudential
supervisory instruments, they cannot be considered responsible for financial stability. In any
case, providing such instruments to central banks should not be considered as a substitute
for conducting a sound monetary policy unequivocally committed to the primary objective of
maintaining price stability. Thank you for your attention.
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