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|  | Riccardo Sorrentino, born in 1964, has worked at Il Sole-24 Ore since 1992. In the past years, he has attended several international summits, including the Palermo G-7 of Finance Ministers and Central Bankers in 2001, and the WTO conferences of Cancun (2003) and Hong Kong (2005) and he has covered several G-10 central bank meetings at the BIS and ECB press conferences. As a special correspondent, he has been in The Netherlands; in the US; in Iceland, in Hungary, in Singapore, in Indonesia, in India, in Norway, in Thailand, in Pakistan, in Armenia. In the 2003-2004 winter and in the 2006 summer, he worked at Il Sole 24 Ore's North American bureau in New York. |
| | riccardo.sorrentino@ilsole24ore.com |
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| The Fed and the bubbles, a lesson from the Ecb |
| 19 ottobre 2007 |
It is a strange crisis... After the turmoil triggered by the subprime mortgages, Federal reserve chairman Ben Bernanke lowered interest rates, last month, and the Standard & Poor's index climbed to a new record. What happened? Did the Fed move trigger the stock exchange rally? Maybe no, but that decision surely helped. Is there the risk of another financial bubble, after that on the housing prices? The question is not far-fetched: an unsound monetary policy could inflate a "speculative mania", even if Central bankers in Washington will never admit it.
NO RISKS
First of all, don't worry: there is not a financial bubble inflated by an unwise monetary policy: the S&P's price/earning ratio, at 16.70, is consistent with its own historical average. It is calculated on an estimate of future profits, so it could be undervalued, but it would be too much to argue that the U.S. stock market is overheating.
A UNAVOIDABLE CUT
This is why Ben Bernanke had no hesitations, last month. He decided to cut interest rate by 50 basis points to help the U.S economy. The slowdown of the housing sector is seriously threatening the Gdp growth while, possibly, inflation pressures are calming down. Nevertheless it was not an easy choice, the Fed credibility was at stake and, actually, markets now expect higher consumer prices in the future. Still Bernanke knew that he had to help the banking sector, too important for the monetary policy. Besides his own seminal studies about this monetary policy channel, he kept in mind the American and the Japanese crises, in 90s, when, because of credit rationing, the financial sector could not transmit monetary impulses from the Central bank to the broader economy. Moreover, despite last interest move the U.S. monetary policy stance is not yet accommodative. Morgan Stanley has estimated the natural rate of interest for the U.S. - varying over time - at 4,15%. At 4,75%, the current level, Fed Funds rates are still on the restrictive side.
THE GHOST OF DEFLATION
Everything's ok? Not at all. The recent Fed track record is not good in all subjects. Its marks are excellent in "handling inflation and economic growth", bad in "leaning against the bubbles". This is a crucial issue. In 2002-03 Alan Greenspan - followed by many other Central bankers all around the world - cut interest rates down to 1% not to stimulate the economy but to avoid the dangers of a deflation that, after few months, turned out to be simply a ghost. That decision was part of a risk management strategy, a sort of an insurance policy to cover a very unlikely but possibly very disruptive risk of a generalized price fall: in Japan, monetary policy has been impotent for many years because of a severe deflation. But the subsequent global accommodative policy - in reality a liquidity deluge - actually inflated the housing bubble in United States and, possibly, elsewhere in the world.
GREENSPAN'S CONUNDRUM
Alan Greenspan was al least aware of the unavoidable consequences of cutting rates: every central banker knows that a cut in interest rates immediately raises asset prices. But the Federal Reserve chairman didn't do anything to avoid the unintended, but predictable, effects of his decision. It is a conundrum: why the "Maestro" decided to insure U.S. economy against deflation, and not against a new bubble? In 90s, the Wall Street irrational exuberance left the market in a mess, before Greenspan's eyes. Still, since 2004, he and his colleagues all over the world simply warned investors against the "mispricing of risks". Too little, maybe, for the direct effect of the monetary deluge they sparked off.
UNSOUND RULES?
Confronted by asset-price inflation, the Fed always follows one rule, said David Woo at Barclays: "When a bubble inflates, do nothing; after the bursting go cleaning everything up". Is it a sound policy? Many economists think so. One of them wrote, in 2001: "It is very hard for monetary authorities to identify that a bubble has actually developed. To assume that they can is to assume that the monetary authorities have better information and predictive ability than the private sector. If the central bank has no informational advantage, then if it knows that a bubble has developed that will eventually crash, then the market knows this too and then the bubble would unravel and thus would be unlikely to develop. Without an informational advantage, the central bank is as likely to mispredict the presence of a bubble as the private market and thus will frequently be mistaken thus frequently pursuing the wrong monetary policy". The author? Frederic Mishkin, that since 2006 has been a member of the Federal Reserve Board of governors.
«HEAD I WIN, TAILS YOU LOSE»
Ben Bernanke agrees. Totally. In 2002 he gave a speech about "Asset-price "Bubbles" and Monetary Policy" before the New York Chapter of the National Association for Business Economics. He focused on the situations that develop after a financial liberalization or when controls are loosening. In this case a financial institution, he said, "can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net - the classic "head I win, tails you lose" situation. When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable [...] crackdown stops the flow of credit and leads to an asset-price crash".
COLLATERAL DAMAGE
The causes of these bubbles, according Bernanke, are loose controls. So he could argue that central banks are not the appropriate institutions to handle asset-price bubbles and reject, as a central banker, the responsibility to handle such situations. "Monetary policy - he said - is not a useful tool for achieving this objective. Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy".
NO «SAFE POPPING»
Collateral damage? Bernanke has a point, here: "If a bubble [...] is actually in progress, then investors are presumably expecting outsized returns: 10, 15, 20 percent or more annually. Is it plausible that an increase of ½ percentage point in short term interest rates, unaccompanied by any significant slowdown in the broader economy, will induce speculators to think twice about their equity investments?" Raising rates to prickle a bubble could spark off undesirable effects: "The rate hike will tend to weaken the macroeconomic fundamentals through the usual channels, while the asset bubble, if there is one, may well proceed unchecked. (...) In short we cannot practice "safe popping", at least not with the blunt tool of monetary policy".
MICRO POLICIES?
Bernanke has a different approach: "micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects": supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practises, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed. Nothing else.
MARKET'S CRITICISMS
Now that a new bubble has burst, market analysts raise an eyebrow. They disagree: "Bubbles - wrote last month, in a report, Paul Sheard at Lehman Brothers - are all about markets diverging from fundamentals. Central banks, not being part of the market, but having armies of professional economists, can judge whether such a divergence has occurred. No one said identifying a bubble is easy but central banking is all about making tough judgment calls".
«LET'S LEAN AGAINST BUBBLES»
It is not a novel objection. The International Monetary Fund, after the 2000 stock market crash, advocated a strategy to "lean against bubbles", acting pre-emptively through monetary or fiscal policies. It is possible, the Imf said, "where signs of overvaluation (undervaluation) are generalized across the different assets and, in particular, when both stock prices and property prices rise (drop) well above (below) historical or estimated equilibrium trends". In this case "in light of the potentially disruptive effects that asset price swings can have on financial sector soundness and private sector solvency (even in financial systems that appear to be well-regulated ex ante), the case for some policy tightening is strengthened whenever high asset price inflation is accompanied by rapid credit and money growth, and vice versa".
MONEY AND CREDIT
This is a key point: credit and money do matter, and following the Federal Reserve rule could be dangerous. This is the lesson from the European central bank: "It has been shown that [...] increasing liquidity after the bust, but not withdrawing it during the boom - said in 2003 Otmar Issing, then member of the Ecb executive board - can be responsible for creating asset price bubbles in the first place".
THE DOLLAR BUBBLE
According to Otmar Issing, a Central bank can successfully handle the asset price inflation, and actually the Ecb did prickle a bubble of the U.S. dollar. It was in 2000, when it intervened to stop the fall of the euro. Moreover, argued Issing, it is easier to recognize a financial bubble than incoming inflation pressures "Some very simple indicators of bubble - he said - based for example on price/earning ratios or recursive detrending methods, exist, and they are applicable in real time, not only ex post".
EASIER THAN COPING WITH INFLATION
Is it too difficult? No, argued Issing: "Other concepts on which we base monetary policy, like the output gap, are also difficult to measure: we just try to cope with the problems instead of ignoring the variable, although admittedly the degree of uncertainty is likely to be higher for estimating asset price misalignments". To decide what to do is a little more tough, but not impossible: "It has been shown - he stated, drawing from the Ecb experience on the euro/dollar - that in some cases the important variable to trigger a central bank reaction should not be the degree of over- or undervaluation, but the probability of a sudden price reversal. The latter is also difficult to estimate but at times a sufficiently sophisticated risk analysis could deliver valuable input for policy decisions".
«MONEY MATTERS»
Two years later, in December 2005, Issing further elaborated his thoughts. He wrote an article on The Financial Times about the monetary aggregates, criticised as an old-fashioned tool in economic analysis and in monetary policy: "The monetary analysis [a part of the Ecb strategy] has provided - he stated - a framework within which to identify, discuss and communicate in a timely way the growing challenges posed by financial imbalances and inflated asset prices. It has become widely recognised that, with consumer price inflation well anchored, overly accommodative monetary policies may lead to asset price inflation. Over longer horizons, this may prove hazardous to price and macroeconomic stability".
GLOBAL RESPONSIBILITIES
In this files, the central bankers responsibilities are truly global. In 2000, the Imf explaind that "excess money growth at the aggregate gG7 level is consistently related to higher real stocks returns and lower real interest rates". Moreover "there is evidence of significant liquidity spillovers across G-7 countries. An increase in excess money growth in one G-7 country is consistent with higher real stock returns and lower real interest rates in other G-7 countries". If Fed (or the Ecb, or the Boj) inflates money supply, United States, Europe and Asia would suffer because of that policy.
«MONEY DOESN'T MATTER»
What Central Bankers at the Federal Reserve think about this approach? They simply disagree, depriving the monetary policy of an important analytic and strategic tool. In 90s they concluded that money aggregates simply don't matter in United States. It is true, in U.S. likewise in the euro zone, speaking about inflation - in a two years horizon - and economic growth: "The empirical relationship between money growth and variables such as inflation and nominal output growth - said Bernanke in November 2006 - has continued to be unstable at times." But Fed governors went even further. In 2005, Roger Ferguson, then vice Chairman, argued: "We do find a positive correlation between growth rates of real house prices and M3, but the correlation does not seem to hold for real asset prices more generally, including, in particular, equities". As a result, since March 2006 statistics about M3 have been unavailable in United States. It was the final step of a huge mistake, maybe. Not yet rectified. |
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