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Thursday, March 28, 2024

Comments On Asset Prices And Inflation Targeting

This is an unedited manuscript excerpt, from a chapter that discusses how asset price changes relate to inflation.

Even if one believes that asset price increases represent inflation, the general reaction among North American central bankers would be to think you are crazy if you think asset prices should be included within an inflation target mandate. (I am less sure about the reaction of Continental European central bankers.) Although they might accept that exuberance in financial markets should be toned down, targeting asset prices directly poses many problems.

Embedded in this reaction is the conventional belief that raising the policy rate tends to slow inflation, while cutting them tends to raise the inflation. I must note that many proponents of Modern Monetary Theory disagree with that conventional belief – but explaining that divergence is out of the scope of this book. (It is explained in my book Modern Monetary Theory and the Recovery.) For simplicity, I will accept the conventional view here.

(One related problem is that if interest rates directly feed into inflation, then inflation will rise if the central bank hikes rates. This conflicts with the conventional view. As such, the Bank of England stripped the mortgage interest component out of the Retail Price Index.)

If we just look asset prices, we see two major problems with having them show directly up inside the inflation measure used in the inflation target. Firstly, financial asset prices are quite volatile relative to most consumer prices. Secondly, there is no way of targeting risk asset prices without blowing up the economy. (Although bonds are a financial asset, it is easy for the central bank to stop their prices from changing – they can peg interest rates along the curve. This idea sends most conventional economists straight to the fainting couch, it has been done historically (such as in the Second World War in the United States, and more recently, Japan). However, locking interest rates in this way largely eliminates flexibility in setting interest rates, which is conventionally believed to be necessary for inflation targeting.)

Equity prices go up and down much faster than the business cycle. If the central bank targeted them directly, they would end up cutting and hiking rates multiple times within a business cycle, which is presumed to destabilise the economy. Furthermore, equity prices may react to central bank movements. For example, imagine that equity prices are rising too rapidly. The central bank then hikes rates to counter this. Imagine then that equity holders panic, and prices collapse. What is the central bank supposed to do – cut rates again? (This is obvious to anyone other than the people who pin the blame for their inaccurate equity forecasts on the central bank, which is remarkably common among people who tend to be wrong about equity markets.)

Rapid interest rate movements by the central bank are going to spook borrowers and lenders. Markets would likely build in large risk premia, and pretty much everyone would start sourcing finance in other markets.

Even targeting slow-moving house prices poses dangers. To the extent that house prices reflect long-term interest rates, rising house prices are a side effect of a low interest rate environment. That environment is typically the result of the central attempting to avoid a recession when economic growth is sluggish. Hiking rates to target house prices is runs exactly counter to the desire to boost growth. Meanwhile, interest rates are not the only thing affecting house prices. Idiotic decisions in other spheres of policymaking can generate a housing boom or bust. Finally, the housing market is like any market run by humans – it has mood swings. The housing market may remain impervious to rate hikes for some time – until there is a panic that precipitates a collapse. Given the importance of residential investment within the economy, and the risks posed by widespread mortgage defaults, housing busts generally trigger ugly recessions.

My view is that the belief that central banks can easily target asset prices comes from an extremely dubious analogy to the Gold Standard – where the gold price was pegged. However, the reasons why the Gold Standard functioned no longer apply to any financial asset.

·        Once international financial capitalism developed, the Gold Standard is best seen as a currency peg system. What mattered economically was the fixed exchange rates between the major economies. Gold was just the mechanism to adjust for capital flows across currencies. No financial asset can replace this at present -even gold. Unilaterally pegging your currency to a risk asset like gold is not going to change much. If your economy is large, you are just running a price control scheme for one financial asset – which other actors will attempt to exploit. If your economy is small, your exchange rate will fluctuate wildly based on speculation in some other market.

  • The political establishment built its world view around being willing to make sacrifices to restore previous exchange rates. However, only a small handful of people think this is a good idea, and so pegs lack political credibility.

  • Gold is a collectible that generates no cash flow, and its consumption by industry is largely insignificant when compared to existing above-ground inventories. Other assets either have cash flows that need to be priced or are commodities with relatively small inventories. There is no way for them to credibly have constant prices in a dynamic economy.

  • Earlier generations of financial market participants had an ideological belief that the gold peg system was credible. Modern market participants will speculate against any peg arrangement. The problem with defending pegs is that attacking them is a low-risk investment (since the price is largely locked) with a high potential pay off if the peg breaks.

If risk asset market prices reacted in a predictable fashion to the policy rate, it should be easy to generate models that generate massive profits by inputting market-expectations for the policy rate – which are decent over short horizons (outside crises). Such models are noticeably small on the ground. Although people (including myself) enjoy giving central bankers a hard time, most of the sensible ones have come to terms with that observation.

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(c) Brian Romanchuk 2024

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