Group Says Fed Must Look to Equities, Real Estate as Movement Indicators
By DAVID WESSEL Staff Reporter of THE WALL STREET JOURNAL
GENEVA -- An unusual quartet of economists, challenging conventional wisdom among central bankers and academics, say the U.S. Federal Reserve and its counterparts should raise interest rates when stock markets or real-estate prices are grotesquely out of line with fundamentals or rise well above historical norms.
"Incorporating asset prices more systematically into the policy-making process can be beneficial for economic performance, "they conclude in an attempt to influence the policies of world central bankers. Had the Fed been following their advice, they say, U.S. short-term interest rates would have been around 7.25% late last year, about two percentage points higher than they were.
Their provocative argument is likely to draw attention because the four are firmly within the mainstream fraternity of central-bank thinkers. They are: Stephen Cecchetti, a former Federal Reserve Bank of New York research director who is now at Ohio State University; Sushil Wadhwani, a current member of the Bank of England's Monetary Policy Committee; John Lipsky, Chase Manhattan Bank's chief economist; and Hans Genberg of the Graduate Institute of International Studies here.
Current central-bank dogma, shaped by the mistakes made by the Fed in the late 1920s, holds that policy makers should focus primarily on stabilizing prices of goods and services and take stock and real-estate prices into account only to the extent that they influence consumer and business spending.
A Superstrong Economy?
Many central bankers and academics say using interest rates to prick stock-market bubbles risks confusing markets, undermines public support for central banks and could endanger economic stability. They also argue no one can tell when a rising stock market is a bubble rather than a reflection of a superstrong economy.
The Geneva quartet acknowledges that others are "hostile to the notion of taking direct action to deal with misalignments because of the difficulties associated with detecting bubbles." But they argue that central banks already rely on measures that are just as difficult to estimate accurately -- such as the quantity of goods and services an economy can produce without generating inflation.
They say that economies would do better if central bankers explicitly reacted to stock-market and real-estate market bubbles or crashes. "It does make sense -- in terms of the ultimate objective of reducing inflation or output volatility [avoiding recessions] for central banks to react both to asset-price misalignments and to their inflation forecast," they say.
The report, "Asset Prices and Central Bank Policy," is to be published next month by the Graduate Institute's International Center for Monetary and Banking Studies.
Intellectual Justification
No matter what the rhetoric, central banks do react to big stock-market moves, as the Fed did when it opened the credit spigots after the 1987 stock-market crash and as it appears to be doing now. The significance of the Geneva report is the intellectual justification it offers for that approach.
The debate over the level of the U.S. stock market has gone on for so long that academic economists, who often ponder yesterday's crises, are now thinking about today's hot issues. In an influential paper presented at a Federal Reserve Bank of Kansas City conference last summer, warmly received by U.S. and other central bankers, Ben Bernanke of Princeton University and Mark Gertler of New York University argued that central banks should never respond to stock markets or other asset markets -- except as they signal changes in the outlook for inflation. The Geneva report attacks that analysis.
'Unsustainable Buildup'?
Last month, International Monetary Fund economists cited "sound conceptual reasons and ample historical evidence" for central banks to raise interest rates to resist "an apparently unsustainable buildup of asset prices." The IMF prescribed higher rates when stock and property prices soar in tandem and when asset-price increases are accompanied by rapid growth in money and credit, falling private-saving rates and large current-account trade deficits.
Some central bankers shy away from trying to influence stock markets because of mistakes made by their predecessors. In the late 1920s, for example, the Fed set out to prick a bubble and then failed to react appropriately to the 1929 crash, contributing to the Great Depression. The Bank of Japan is criticized for fueling a bubble in stock and land prices in the late 1980s with rate cuts aimed at reducing the yen's value, for bursting the bubble with rate increases in 1989 and for not responding aggressively to the ensuing recession.
According to transcripts of Fed deliberations, Chairman Alan Greenspan has been worried about soaring U.S. stock prices for at least six years, and he has occasionally talked about the issue in public. Mr. Greenspan raised questions about "irrational exuberance" in late 1996, suggested earlier this year that stock prices ought to rise only as fast as household income and later argued that soaring stock prices were fueling too much spending in the U.S.