What central banks should target and why

It has been a month since the rise in volatility and the correction in global financial and some real assets began. Globally, many assets, including real ones such as industrial and precious metals, went up in prices well beyond levels justified by fundamentals. Indeed, their spectacular rise in March and April clearly indicated the role of liquidity, rather than fundamentals, in their ascent. The roller-coaster ride makes one wonder if anything more should?ve been done to stem the excessive rise caused by irrational speculation in the first place.

In an interesting working paper, William R White of the monetary and economics department of the Bank for International Settlements (BIS) makes a compelling case ?for looking at financial sector developments, and their potential to threaten rapid and sustainable output growth, as new indicators which ought to help guide the conduct of monetary policy? (Is price stability enough? BIS Working Paper No 205, April 2006).

The experience of the developed world since the 70s has shown that costs associated with lowering inflation (higher unemployment) have been overstated. By the same token, he argues, the costs associated with disinflation or deflation have been overstated. The state of the world today, with technological advancement, relatively freer mobility of factors of production (facilitated by technology, if not by policy) and financial innovation resembles closely the world that prevailed prior to World War I, where disinflation or deflation was associated with rising productivity, falling prices and strong growth in output and employment.

He also notes that numerous financial and economic crises have been preceded by remarkably stable and low inflation. Hence, inflation was neither the proximate nor the ultimate cause of those crises. However, in all those cases, there was a confluence of unusually large increases in asset prices, credit and investment growth, with a rise in household debt or falling savings chipping in, in some cases.

If central bank-ers systematically react asymmetrically to rising (not raising policy rates that much) and to falling asset prices (lowering these immediately and in large measures), then over time, policy rates would be driven to zero. The nominal zero bound on rates would then cause central bankers to resort to unconventional policy measures (quantitative easing), with uncertain and unknown outcomes. Further, long periods of low rates would reduce incentives to save and encourage accumulation of debt. It would also cause financial markets to remain incomplete, as there would be less need for market sources of finance in periods of low rates and abundant liquidity in the banking system.

His arguments, as summarised here, are compelling enough to warrant a re-examination of current policy, that places a disproportionate emphasis on maintaining the stability of inflation rates in the prices of currently produced goods and services.

There are many reasons why voices such as his and that of India?s Reserve Bank governor would be in a minority. First, economists who believe in free markets would resist such a shift. The economics of free markets favours prices over quantities, particularly for discretionary policy-making. To them, it would conjure images of centrally-planned economies rationing everything, including credit.

Of course, reducing the emphasis on prices relative to quantities would also mark the end of an era that began with Paul Volcker in the US, who abandoned money supply targets and targeted interest rates in the late 70s. It might even be appropriate, for Mr Volcker was responding to a different problem. But, putting it past ideologues might be stiff.

Second, the financial services industry would be up in arms whenever a central banker tries to ?limit? or ?restrain? increases in asset prices. The industry is built on rising asset prices and the more they rise, the more it prospers. It does not matter if it risks a painful correction later. The ?mopping up? is left to successors. Managerial incentive systems reward short-term milestones rather than long-term outcomes. Hence, today?s profits matter more than tomorrow?s. Indeed, as YV Reddy?s experience in India shows, a central banker who tries to ?moderate? the rise in asset prices risks not only unpopularity with the world of finance, but also with the ministry of finance!

The third argument, related to the second, is that targeting asset prices is difficult, if not impossible, in democracies. Inflation in prices of goods and services causes pain; that in asset prices causes pleasure. This difference in sensory impacts is hugely important. There would never be a popular mandate for targeting asset prices due to their relative impacts on current consumer welfare, even if it ultimately proves transient.

Fourth, there is genuine deterioration in the quality of policy discourse through the world. In election after election in the US, commentators lament this deterioration and in policy prescriptions of candidates. Painful choices are to be ignored, not articulated. The culture of consumption has also embraced the primacy of the present over the future. Hence, there is emphasis on instant over long-term gratification. So, a monetary policy framework broader than the current one would be out of tune with the ethos of modern society and so, invariably fail to find acceptance.

Therefore, it is safe to predict working papers, such as the one discussed in this column, would remain so. Only when a crisis entailing both economic and social costs occurs would there be serious re-examination of the current framework. Until then, be prepared to participate in wild booms and debilitating busts. Or, more wisely, stay out and watch the insanity unfold. But then, be prepared to be considered a fully clothed idiot in the land of the naked.

?The writer is founder-director of Libran Asset Management (Pte) Ltd, based in Singapore. The views are personal