Monetary policy and asset prices revisited.

• Author: Kohn, Donald L.
• Position: Report

We are in the midst of a global financial crisis that is now weighing heavily on economies around the world. Although the outlook remains extremely uncertain, both the fragility of the financial system and the weakness in real activity seem likely to persist for a while. To promote maximum sustainable economic growth and price stability, the Federal Reserve has responded to this crisis by easing monetary policy markedly, and we have greatly expanded our liquidity facilities to keep credit flowing when private lenders have become reluctant or unable to do so. Other central banks have also cut policy rates significantly and expanded their lending. In addition, the federal government and governments around the world have taken extraordinary actions to strengthen financial systems to preserve the ability of households and businesses to borrow and spend.

The current situation is so severe that it calls for careful review of how such a crisis evolved and how we can prevent a similar situation from happening again. This conference is a welcome step in that review, as it asks about the lessons we have learned, particularly for monetary policy, from the collapse of subprime lending and the preceding house-price bubble--developments that contributed importantly to the present financial crisis.

I would like to reflect on some of what I, in my role as a monetary policymaker, have learned from recent developments in the housing sector and, more broadly, in financial markets as a whole. In doing so, I will revisit the remarks I made in 2006 in Frankfurt at a colloquium honoring Otmar Issing (Kohn 2006). There I argued that a central bank facing a possible asset bubble would have to surmount some high hurdles before it would be justified in tightening policy beyond what the outlook for output and inflation would require, after taking into account past and projected asset price developments. In the aftermath of the collapse of the housing market and in the midst of the ensuing financial and economic turmoil, does that conclusion still hold? More time and study will be needed before we can be confident about the lessons of the current crisis. But to foreshadow the remainder of these remarks, based on what we know today, I still have serious questions about whether trying to use monetary policy to check speculative activity on a regular, systematic basis would yield benefits that outweigh its costs.

I hasten to add that it is evident from the current crisis that much has to change on the regulatory front. Governments around the world face the challenge of revamping the regulatory structure governing financial markets. And changes in this area, I believe, will prove to be the most necessary and effective at reducing the odds on another severe financial crisis. Today, however, I will focus on some of the lessons of the current crisis for monetary policy.

Alternative Strategies for Addressing Asset Price Bubbles

In my 2006 speech, I discussed two different strategies for monetary policy to deal with a possible asset price bubble--the "conventional strategy" and "extra action." A central bank following the conventional strategy does not attempt to use monetary policy to influence the speculative component of asset prices, on the assumption that it has little ability to do so and that any attempt will only result in suboptimal economic performance in the medium run. Instead, the central bank responds to asset price movements, whether driven by fundamentals or not, only to the degree that those movements have implications for future output and inflation. This conventional strategy conforms to the Federal Reserve's dual mandate under the law and it has been our policy strategy; it also has been consistent with the practices of most inflation-targeting central banks.

However, some observers have argued for a more activist policy than this one. Specifically, they have urged central banks, upon perceiving the development of an asset bubble, to take extra action by tightening policy beyond what the conventional strategy would suggest, with the hope of limiting the size of the bubble and thus the fallout from its deflation. Such a strategy, if successful, could deliver substantial benefits, and a number of central bankers have talked about the need to consider a policy of extra action on occasion, and perhaps have even implemented such a strategy. However, taking extra action also would entail some costs, such as creating, for a time, higher unemployment and lower inflation than would otherwise be desired.

In assessing these two alternatives for monetary policy, in the 2006 speech I concluded that a strategy of extra action might be justified if three tough conditions were met. First, policymakers must be able to identify bubbles in a timely fashion with reasonable confidence. Second, a somewhat tighter monetary policy must have a high probability that it will help to check at least some of the speculative activity. And third, the expected improvement in future economic performance that would result from the curtailment of the bubble must be sufficiently great. Of course, we live in an uncertain world, and accordingly policymakers should always be open to the possibility that these conditions might be satisfied and that extra action would be appropriate. But my thought at the time was that, in practice, the likelihood of ever meeting the three conditions seemed remote. In the aftermath of the bursting of the housing bubble, however, the severity of the fallout might seem to call this judgment into question. So let's reexamine each of the three conditions and see what the current crisis has taught us.

Potential Gain from Limiting Bubbles

Let me start with my third condition, the potential gain from limiting bubbles, because this is where my views have changed the most. Although I was concerned about the potential fallout from a collapse of the housing market, I think it is fair to say that these costs have turned out to be much greater than I and many other observers imagined. In particular, I and other observers underestimated the potential for house prices to decline substantially, the degree to which such a decline would create difficulties for homeowners, and, most important, the vulnerability of the broader financial system to these events.

In retrospect, I may have been unduly comforted by the resilience of the U.S. economy to the collapse of the high-tech bubble, to the earlier Russian debt default and failure of Long-Term Capital Management, and even to the commercial and residential real estate debacles of the late 1980s and early 1990s (as difficult as that recovery was). But mopping up after this asset price bubble has turned out to be much harder because of its greater magnitude, the centrality of residential housing and finance to our...