Feb 25, 2005

Inflation Targets and Asset Bubbles

From the Economist:
Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.
The author then gets a bit caustic with the Fed for reluctance to consider the overall liquidity picture and concludes with this.
During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.
While centering on the need to include asset prices in inflation measures the article falls a bit short by suggesting central banks should consider asset prices in their policy decisions. A better solution is to remove asset prices from central bank control. Robert Shiller discusses the Chilean UF (unit of development) in his book The New Financial Order (Amazon) as an example of an alternative system to limit central bank influence over asset prices. The UF is an inflation indexed unit of account which is repriced daily such that everyone knows the correct price of a UF in Pesos. The UF was created in 1967 and has become widely used for pricing long-term contracts such as housing prices and mortgages while pesos are still used for day-to-day purchases and salaries.

I am getting a bit out of my area of expertise but I am pretty sure the Fed (and probably the world) is running into the problem the Economist describes with asset prices demonstrating large value swings while goods prices remain stable. These swings are making it impossible to effectively manage liquidity in the system. Rather than giving central banks the difficult task of adjust policy to correct asset prices I think it is better to create a mechanism for asset price stability outside of central bank control.

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