Saturday, May 17, 2008

Heal Thyself

The Fed has finally decided that they need to look at their policies regarding potential bubbles. Here is Fed Governor Frederic Mishkin in a recent speech:

How Should We Respond to Asset Price Bubbles?

Over the centuries, economies have periodically been subject to asset price bubbles--pronounced increases in asset prices that depart from fundamental values and eventually crash resoundingly. Because economies often fare very poorly after a bubble bursts, central bankers need to think hard about how they should address such bubbles. This issue has become especially topical of late because of the rapid rise and subsequent decline in residential housing prices this decade. The recent drop in house prices in many markets around the country has been accompanied by increasing rates of defaults on mortgage loans and home foreclosures. These developments have created hardship for the families who are forced to leave their homes and have disrupted communities; in addition, the developments have contributed to a major shock to the financial system, with sharp increases in credit spreads and large losses to financial institutions. As many have pointed out, the damage to households' credit and the financial disruption have been a drag on the U.S. economy, which has led to a slowing of economic growth and a recent decline in employment.

Later he offers his opinion regarding how Central Bankers should respond:

To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.

Why do central bankers cling to the notion that inflation is the rise in prices rather than the cause of the rise in prices. The traditional - and correct in my opinion - definition of inflation is an increase in the supply of money. Inflation causes the rise in prices and there is no way to predict which prices will be affected most. It could be asset prices or it could be consumer prices - there is no way to know. The Fed should concentrate on controlling the one thing over which they have direct control - the money supply.

Others, such as Minneapolis Fed Governor Gary Stern, have said the traditional approach to bubbles (such as that outlined by Mishkin) need to be rethought:

“If you look at the aftermath of the decline in equity values from 2000 to 2002, and you look at the aftermath of the decline in home prices, activity in residential construction and all the problems in mortgage markets… the aftermath hasn’t been costless and it hasn’t been easy to deal with,” he said Tuesday in an interview with The Wall Street Journal. “I think it legitimately opens up the question in my mind. It’s certainly worth taking another look at what are the costs and the difficulties of dealing with the aftermath? Is there something that could be done on the front end?”

Unfortunately, it doesn't appear that Stern gets it either. Why is it so hard for central bankers to understand that if you ease credit terms, people will borrow more money? And if you make the terms too good, people will borrow a lot of money? The Fed needs to look in the mirror to discover the cause and the cure for bubbles. Heal Thyself.

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