urban backstrom : asset markets and monetary policy speech by mr urban backstrom, governor of the sveriges riksbank and chairman of the board of directors and president of the bank for international settlements, at a conference organised by the riksbank and the stockholm school of economics, held in stockholm, on 16 june 2000. * * * ladies and gentlemen, it gives me great pleasure to welcome you to this conference on asset markets and monetary policy that the riksbank and the stockholm school of economics are jointly organising. the riksbank has the ambition to host a conference every other year on a topical subject. two years ago we organised a conference jointly with the institute for international economic studies on monetary policy rules. this year i am very pleased to announce that we will again be able to present a set of papers written by scholars of the highest international academic standard and on a subject matter that is extremely topical : asset markets and monetary policy. in my opening remarks two years ago i suggested that the question of monetary policy and asset prices should be a topic for a future conference. the interaction between asset prices, the real economy, and monetary policy is by no means a new matter for central bankers and economists, but the development of asset markets in the last few years has brought the question to the forefront of the policy debate. for a practitioner of monetary policy like myself, this area contains a number of difficult issues. i shall be raising some of them this morning and they will also be discussed during the conference. by the end of the conference i hope we will be able to look back on a fruitful discussion and have a better understanding of the issues and problems involved. how should monetary policy respond to movements in asset prices? this depends on how the central bank chooses to use the information contained in asset prices. in a regime that explicitly targets inflation, asset prices are taken into account via the effects on aggregate demand. rising share prices increase household wealth and that would raise consumption for a given level of income if these increases in wealth are considered to be of a permanent nature. at the same time, consumer confidence boosted by higher share prices could potentially make individuals more prone to spend their increased wealth. an increase in share prices also makes investment more attractive to firms since it increases collateral values and lowers the cost of new capital relative to existing capital. if share prices predict higher expected output growth, this could also lead to more investment. if the asset prices on which households and firms base their consumption and investment decisions prove

fundamentals, rather than the “ irrational exuberance ” of investors, is easier said than done. how does a speculative asset price bubble get started and how do we spot it? and if we spot it, what do we do about it? in most countries the risks associated with a property price bubble would probably be considered to be greater than in the case of an equity price bubble. this is because in most countries banks are more exposed to risks in the property market, since real estate is used as collateral for a considerable amount of bank loans. the bursting of a large property price bubble can have serious effects on financial intermediation. this could motivate an early monetary policy response. the cost of this pre - emptive strike strategy would have to be weighed against the fact that inflation and real activity will be lower than desired in the short term. is this a price worth paying to maintain stability in the financial system? in order to answer that question, we need to know how sensitive the financial system is to a severe fall in property prices? another problem with trying to act pre - emptively is, how do we spot the price bubble in time? so even though in a conflict between short - un price stability and financial stability, the latter were to be viewed as the more important, implementing such a policy could be fraught with substantial practical problems. the grounds for a pre - emptive strike against an equity price bubble are perhaps less compelling than for a property price bubble. the us experience from the 1987 stock market crash seems to be that, with an appropriately conducted monetary policy, the effects on real activity can be relatively small. with new york stock exchange order flows grossly out of balance on 19 october 1987, with the solvency of brokerages and clearing houses in doubt, banks were growing nervous and reluctant to lend. this was a clear case of systemic risk and before the market opened on 20 october the fed affirmed its responsibilities to serve as a lender of last resort and also substantially eased monetary policy. a financial meltdown was avoided and the effects on the real economy seem to have been negligible. in the 1990s, the global monetary policy picture has in many countries been very different compared to the 1980s. low inflation seems to have become the norm rather than the exception. if monetary policy is successful in providing price stability, does that mean that the risk of financial instability will be smaller? in order for a financial crisis to have severe effects on the real economy, substantial