Ben and his Avatar

I can’t help noting the coincidence of Bernanke’s nomination as both “Man of the Year” and “The Definition of Moral Hazard” in the same week as the release of Avatar… And while Ben has probably settled on which “body” he belongs to, representatives of the voting public have yet to make up their mind.

Should the Fed be the Nation’s Bubble Fighter?

That’s a question recently taken up by the Wall Street Journal. Here are my thoughts. Before we can discuss this issue, we’d need to agree on what we mean by a “bubble”. Here’s one definition that a lot of people may have in mind: a bubble describes a condition where the price of a particular […]

Japan’s Growth Embarrassingly Revised Down by 3.5%

A friend Scott caught this article on Bloomberg about the latest economic figures out of Japan: Japan’s economy expanded less than a third of the pace initially reported in the three months to September as companies slashed spending. Gross domestic product rose at an annual 1.3 percent pace, slower than the 4.8 percent reported in […]

Inflation Expectations Continue to Inch Higher

One of the supporting pillars in the recent rally is the recognition that inflation isn’t a problem. Last year’s financial crisis knocked the stuffing out of the system’s tendency to devalue the purchasing power of fiat currencies over time. The net result is an unusual level of economic cover for keeping interest rates low–really low. […]

The Arrival of Asset Prices in Monetary Policy

Once upon a (not long ago) time, there was a widely established set of blueprints for regimes of monetary and exchange rate policies, one expected to fit not only the full range of economies in the global arena, but also to serve as a guide for international monetary cooperation. Confidence in the effectiveness of those blueprints has been shattered by the scale and simultaneity of asset price booms and busts that led to the current global economic crisis. A reshuffle of views on monetary and exchange rate policies may turn out to be a companion to the revision of financial regulation.

It is now increasingly accepted that, to some degree and width, mainstreaming reactions to asset price moves in monetary policy is to become a new norm. It is also becoming clear that the previous world of theoretical determinacy and optimum rules of conduct is to give place to less-obvious policy choices and more discretion.

The purpose of this note is to highlight how the special complexity and indeterminacy intrinsic to international monetary-financial relations will deepen under the new regime. In the case of financial transactions between advanced financial systems and emerging markets, there is in addition an asymmetrical impact in terms of higher foreign reserve requirements on the latter.

The determinate world of inflation targeting and exchange-rate corner solutions

“The past 10 years have been the decade of inflation targeting. (…) Narrowly defined, inflation targeting commits central banks to annual inflation goals, invariably measured by the consumer price index (CPI), and to being judged on their ability to hit those targets. Flexible inflation targeting allows central banks to aim at both output and inflation, as enshrined in the famous Taylor Rule. The orthodoxy says that central banks should essentially pay no attention to asset prices, the exchange rate, or export prices, except to the extent that they are harbingers of inflation”(Frankel. 2009).

Asset price cycles were seen as basically harmless – or non-significant as a channel of transmission of monetary policy, as in the case of developing economies without financial depth. Even when the frequent appearance of bubbles started to be acknowledged, the belief – “the Greenspan doctrine” – was that attempts to detect and prick them at an early stage would be impossible to accomplish and potentially harmful. If necessary, resorting to interest rate cuts to safeguard the economy after bubble bursts would be a safer procedure.

Low and stable inflation could then be attained through a forecast-oriented, anticipatory manipulation of basic interest rates, as the single focus for monetary authorities. Movements of floating nominal exchange rates would reinforce the effectiveness of interest rates set to target inflation. Stable inflation would also lead to low risk premiums and higher financial stability.

In the case of small countries, fixing the nominal exchange rate and abdicating of monetary policy would import stability from inflation-targeting countries. The “Great Moderation” period, with developed economies exhibiting relatively low inflation rates and output fluctuations from mid-80s onward, seemed to vindicate that confidence.

This world of presumed stable and stabilizing monetary and financial spheres was shaken by the global financial crisis. With hindsight, asset price booms and busts became acknowledged as both increasingly pervasive and harmful: real-estate and stock-market booms leading to excess US household debt and to fragile asset-liability structures; a generalized bubble burst pushing the global economy to a quasi-collapse.

Endogenous creation of liquidity and the “sea of bubbles”

Chapter 3 of the latest IMF’s “World Economic Outlook” brings evidence on the presence of real-estate and stock-market asset price busts over the past 40 years (WEO – ch.3). The recent experience with widespread busts of both house and stock prices is singular in the last 40 years (Chart 1). However, one can observe not only the frequency of previous episodes, but also that those “asset price busts are relatively evenly distributed before and after 1985 – a year that broadly marks the beginning of the ‘Great Moderation’” (p.95).


Besides noting the typical economic costs associated with asset price busts, the IMF study detects and points out some leading indicators of busts, namely, “rapidly expanding credit, deteriorating current account balances, and large shifts into residential investment”. As one might nowadays easily expect, with the benefit of hindsight, “inflation and output do not typically display unusual behavior ahead of asset price busts” (p.93). In other words, well behaved inflation and output performance is no guarantee against asset prices acquiring a cyclical life of their own, with potentially dire consequences. The even distribution of episodes of stock market and housing busts before and during the “Great Moderation” (Chart 1) is an illustration of that.

The Fed’s Moving Target: NAIRU

This is the article that I wrote on Angry Bear today. Neal Soss and Henry Mo at Credit Suisse published a very interesting article, “Where is full employment in a more volatile macroeconomy?”, where they argue that the natural (long run) rate of unemployment may be shifting (they do this by showing that the Beveridge […]

Central Bank Rates One Year from Now…FF up 52 bps

The core inflation rate has dropped to 1.4%, while the unemployment rate surged to 9.7%….to date. And barring some unforeseen and positive economic surprise, like renewed confidence driving consumer spending more quickly than anticipated, these variables that define the Fed’s dual mandate are likely to remain outside the Fed’s comfort zone into next year. Therefore, […]

The Scope of Central Bank Independence, and the Accountability Mechanisms that go with This

From Financial Express The rationale for central bank independence The starting point of modern thinking on monetary policy is the issue of central bank independence. Watching the world across the centuries, a pattern has been found that non-independent central banks distort monetary policy to support the incumbent political party. When elections are approaching, rates tend […]