Finding the Right Tool for Dealing with Asset Price Booms

I am mightily pleased to be the MPC speaker at this year’s MPR conference, and to make a presentation to so many market participants. Too late for the years of the Great Moderation, I have joined a central bank just in time for the recovery (we hope and expect) from the worst financial crisis in seventy years. Unsurprisingly, and not unjustifiably, monetary policy as practiced in the run-up to the crisis has come under critical scrutiny. Among the many factors leading to the crisis, too easy or too narrowly focussed monetary policy is now widely cited as a contributing factor. This belief leads naturally to adding consideration, if not targeting, of asset price booms when setting monetary policy.

I agree that the need to do something to pre-empt boom-bust credit cycles is now self-evident on its merits. I agree that central banks must share the responsibility for making that attempt to stabilize the economy. I oppose, however, taking asset prices directly into account into monetary policy (as opposed to noting their effect on forecasts of consumption, investment, et al). I oppose so doing for a very simple reason: trying to manage asset prices, let alone pop bubbles, with monetary policy instruments will not work.

This is now an embattled position to take –many central bankers who previously were sceptical of such measures have changed their views to support “leaning against the wind,” and the sophisticated commentariat has almost universally lent its support. Yet, just because a bad situation calls for a solution does not mean there has to be a way to fix it, at least not with what instruments are on hand. Wishing does not make it so. Furthermore, just because something is so widely believed as to be taken for granted, does not make it true. The belief that monetary conditions are responsible for asset price booms and bubbles, no matter how intuitively obvious it appears to many observers, is not supported by the data.

We would be better off if we could prevent asset price booms and busts, and it is clear that monetary policy as currently practiced is not sufficient to do so. But, if as I will argue, adjusting monetary policy to take asset prices into account will not do it, what will? Several approaches combined are probably necessary. The macro prudential proposals coming out of the work of my colleagues in financial stability at the Bank of England (2009), which go beyond the proposals to date from the Financial Stability Board focusing on cyclically – adjusted capital requirements for banks, is a strong contribution in this effort.3 As we have seen in the experience of countries whose banks were well supervised but still suffered in the crisis, however, it seems to me that even if better designed, concentrating our efforts on just banks is unlikely to be enough. I propose that, as a complementary policy, we also add to our toolkit some changes to real estate taxes and regulation, providing a counter-cyclical element to the structures already in place in that area as well.

I use the term ‘toolkit’ quite deliberately. When it comes to asset price booms, we should think of ourselves as homeowners confronted by a leaky showerhead. This will be far more practically rewarding than talking about unrealistic abstract ideas of ‘liquidity.’ If I have just a hammer in my toolbox, and I take that to the showerhead, I am only going to make things worse, if I hit it hard enough to have any impact at all on the water flow. That is what a monetary policy tightening would do: either nothing, or hit the system so hard that it breaks down. I need a different tool which is right for the job. If the leak is in a small spot, it might be duct tape; if the leak comes from the head being loose, I might need a wrench. But I will get a lot further going to get the right tools rather than insisting on using the hammer that I have at hand.