July 10, 2002
When Should the Federal Reserve Take Away the Punchbowl?

William McChesney Martin, famous Chair of the Federal Reserve in the 1950s and 1960s, once said that the job of the Federal Reserve is to "take away the punchbowl when the party gets really going." But when does the party get "really going"? The overwhelming majority of macroeconomists would agree that times of rapidly-rising price indices and of unemployment rates far below average are signs that the punch bowl has been left on the big table in the middle of the stock exchange for too long. But what if consumer prices are not accelerating, if indicators of labor-market tightness are not exceptional, but if asset prices are going wild and through the roof? What then? There is no consensus.

Here Michael Bordo and Olivier Jeanne weigh in on the side of taking away the punchbowl early if there is asset price inflation along. They base their conclusion on the belief that what goes up must come down, and the fear that when asset prices come down they will generate a large and destructive credit crunch that will be had to fix on the spot without large output losses and high unemployment.

Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy

Michael Bordo and Olivier Jeanne (2002), "Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy" (Cambridge: NBER Working Paper 8966, June).

Abstract: The link between monetary policy and asset price movements has been of perennial interest to policy makers. In this paper we consider the potential case for pre-emptive monetary restrictions when asset price reversals can have serious effects on real output. First, we provide some historical background on two famous asset price reversals: the U.S. stock market crash of 1929 and the bursting of the Japanese bubble in 1989. We then present some stylized facts on boom-bust dynamics in stock and property prices in developed economies. We then discuss the case for a pre-emptive monetary policy in the context a stylized "Dynamic New Keynesian" framework with collateral constraints in the productive sector. We find tah twhether such a policy is warranted depends on the economic conditions in a complex, non-linear way. The optimal policy cannot be summarized by a simple policy rule of the type considered in the inflation-targeting literature.

p. 18: "...our analysis of proactive monetary policy is not premised on the assumption that asset prices deviate from their fundamental values. The essential variable, from the point of view of policymaking, is the risk of a credit crunch induced by an asset market reversal.... [T]he suspicion that an asset market boom is a bubble which will have to burst at some point is an important input in our assessment. However, bubbles are not of the essence... the question would arise even in a world without bubbles. Hence, the debate about proactive versus reactive monetary policies should not be reduced to a debate over the central bank's ability to recognize a bubble when it sees one..."

p. 19: "...boom-busts in asset prices can be very costly in terms of declining output. This was clearly the case in the U.S. Great Depression and in recent Japanese experience. We also argue tha tthere is a case under certain circumstances to use monetary policy in a proactive way to restrict private domestic credit and diffuse an asset price boom to prevent a credit crunch..."

Posted by DeLong at July 10, 2002 01:47 PM

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I think some would argue that excess asset price inflation is indicitive of too much liquidity. I tend to believe that the securitization of debt has broken down the relationship somewhat, I certainly see the argument.

I think the concern at the Fed, and I got this sense when I talked to Bill Poole a few months ago, that they're worried about what they'll do if anything else goes wrong. Where can they go? The ever-diminishing returns of further liquidity could engender inflation and leave the Fed impotent.

Thanks for the link to this paper, it's a good read.

Posted by: Matthew Mullenweg on July 11, 2002 09:25 PM

Ahhh, posting too fast is hazardous. What I meant to say in that extremely obvious first sentence that I've heard many neo-classicists suggest that when liquidity as measure by your monetary aggregate of choice is moving too fast the excess money goes into the asset markets. If you're interested I'll be happy to look up some sources where I've read this, but I can't name any of them off the top of my head.

Posted by: Matthew Mullenweg on July 11, 2002 09:30 PM

To implement this as practical policy it seems one would first need an empirical and reliable method for identifying meaningful asset price inflation on a looking forward basis. So far, bubbles seem to be much more readily identifiable in hindsight.

E.g, much of the economy's strength today derives from continued strength in the housing market -- which is a little odd coming through a recession. Is this an asset price bubble (as the WSJ worried about a couple days ago) or not?

If we don't know with confidence looking forward, policy actions taken to head off such bubbles might succeed in averting seven out of three of them.

Posted by: Jim Glass on July 12, 2002 09:06 PM
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