The role of the Federal Reserve, as the saying has it, is to take away the punch bowl just as the party is getting started. It certainly works just when the labour party is getting started – resulting in sometimes brutal recessions.
But asset bubbles seem more intractable. The established wisdom is that stock bubbles reflect an excess of demand. Therefore, stock bubbles will be affected by the same general rise in interest rates intended to stifle inflation. That’s a view endorsed by Ben Bernanke as long ago as 2001 – well before he was Fed chairman.
But at the world’s annual central bank meet – the Jackson Hole conference in Wyoming in August – Lawrence Christiano, a researcher with the National Bureau of Economic Research, presented a paper co-written with Cosmin Ilut, Roberto Motto and Massimo Rostagno that takes the opposite tack.
To put it in stark terms, stock bubbles happen in low-inflation environments. “We consider 18 stock market boom episodes that occurred in the past 200 years in the United States. We find that, without exception, inflation in each boom is lower than its average value outside of boom periods.
As a result, the authors write, “at least at an informal level, a monetary policy which implements inflation forecast targeting using an interest rate rule would actually destabilize asset markets. The lower-than-average inflation of the boom would induce a fall in the interest rate and thus amplify the rise in stock prices in the boom.”
Still, what does happen is that credit growth increases substantially – at twice the level than during non-boom times. But credit growth has not been taken into account by monetary policy. “Casual reasoning suggests that volatility would be reduced if credit growth were tightened as booms get underway. In practice, this tightening in response to credit growth would not be justifiable based on the inflation outlook alone because booms are not in fact periods of elevated inflation.” What would be a rationale for raising interest rates during a low-inflation period, when the opposite is the practice?
For this, the authors turn to New Keynesian theory. “The expectation that marginal costs in the future will be lower dampens the current rise in prices. The inflation forecast targeting interest rate rule leads the monetary authority to cut the current interest rate and this stimulates current demand for goods. Output expands to meet the additional demand, and so current marginal costs increase. The rise in current marginal costs places upward pressure on current prices. However, this pressure is overwhelmed by the anticipation of lower future marginal costs, so that prices actually fall during the boom.”
That passes through to assets – lowering the cost of capital in anticipation of higher productivity. But that higher productivity is the result of higher capital utilization, not more efficient labour. The key is to so much trim expectations, as it is to find where monetary policy is too loose. Here, the authors model the role of credit growth in a boom cycle.
“We find that when we allow credit growth to play an independent role in that rule, one that goes beyond its role in forecasting inflation, then the interest rate targeting rule’s tendency to produce excessive volatility in response to optimistic expectations about the future is reduced. We interpret this as evidence that credit growth is correlated with the natural rate of interest. The natural rate of interest is what one really wants in the interest rate targeting rule, and credit growth appears to be a good proxy, at least relative to shocks to expectations about the future.”
Maybe the new normal will bring a new monetary policy.