Global
The Morning After
April 03, 2009

By Spyros Andreopoulos & Joachim Fels | London

Bubble lessons. Central banks surveying the post-crisis landscape will undoubtedly sift the rubble for evidence of their own mistakes. The charge is well-known: by allowing money to be too easy for too long, central banks created an asset price bubble that has now burst, with familiar consequences (for an earlier version of the same charge, see J. Fels, Bubble Trouble, August 27, 2003).  For example, as we illustrate, both the Fed and the ECB kept real short rates well below their natural level over the 2002-05 period. Whether guilty as charged or not, the current crisis is likely to provoke a comprehensive rethink of the role of asset prices in monetary policy. What are the likely consequences, and how might central banks adjust their policies?

Traditionally, most central bankers have argued against targeting asset prices. The practical difficulties are such that a central bank could do more harm than good if it tried to prick bubbles (see, for example, ex Fed Governor Mishkin’s speech, Enterprise Risk Management and Mortgage Lending, at the Forecasters’ Club of New York, January 17, 2007). First, asset price bubbles are difficult to identify. At the very least, there is no reason to assume that a central bank would have better information than the markets themselves; but if the markets know that there is a bubble, then it would unravel automatically. Second, the central bank can always ‘mop up’ afterwards if a bubble bursts and there are deflationary consequences. Hence, no pre-emptive action is needed. Third, even if a bubble was reliably identified, monetary policy may not know the appropriate way, or have the appropriate instrument, to prick the bubble.

But the crisis strengthens the case for paying more attention to asset prices. Critics would respond that it is no more difficult to identify asset price bubbles than it is to identify potential output or the natural rate of interest, concepts that virtually all central banks use on a constant basis to conduct monetary policy (see Cecchetti, Genberg, Lipsky, Wadhwani, Asset Prices and Central Bank Policy, Geneva Reports on the World Economy, 2000).  It is also far from clear that markets would prevent bubbles from arising. Factors such as momentum chasing and costly arbitrage may exacerbate bubbles rather than containing them. Recent events – as well as less recent ones, such as Japan’s bubble – have probably discredited the ‘mopping up’ view: the fallout from the bubble may be so severe that it is difficult or even impossible to mop it all up. ‘Mopping up’ also creates moral hazard – the familiar Greenspan put. And pre-emptive action can be justified if preventing asset bubbles may contribute towards greater stability in the medium term – even if this entails a temporary departure from an inflation target. That is, emphasis should be on preventing bubbles from arising in the first place, rather than attempting to prick them once they are there. This would avoid the risk of plunging the economy into recession like the Fed did in 1929. Ironically, the recent crisis could help central banks justify greater short-term deviations from the inflation target with little loss of credibility. The deviations could be explained to the public as a price to pay in the short term in order to avoid repetition of crises, with all their traumatic consequences, in the future.

How to incorporate asset prices? Deciding to pay more attention to asset prices is easier said than done, of course. The real question is how to incorporate asset prices into monetary policy strategy. In principle, central banks are faced with three options:

•           Asset prices may be included in the price index that the central bank targets: This raises a host of questions: which asset prices should be included, and with what weight? For example, the inclusion of equities may be problematic, as all but a very small weight to equity prices may render the price index too volatile to be a meaningful target. House prices, on the other hand, are a more plausible candidate. In many countries, the CPI already includes some measure of housing costs, such as owner-equivalent rents (OER) in the US.  However, the correlation between actual house prices and OER has been fairly low during the surge in house prices. In Europe, by contrast, the HICP inflation measure still excludes the costs of owner-occupied housing.    

•           Watching asset prices closely and occasionally leaning against the wind if need be, without explicitly targeting a measure of inflation that includes asset prices: This may be a sensible strategy because asset price movements include useful information about future demand, and hence future inflation.

•           Watching money and credit aggregates and incorporating them into the monetary policy strategy: The rationale here is that asset price bubbles are usually preceded by strong growth in money and credit. The ECB’s ‘second pillar’ strategy goes in this direction – though with hindsight it could be argued that the ECB ignored the consequences of very strong money supply and credit growth for too long.

A second instrument apart from interest rates? Ideally, in order to target asset prices in addition to inflation, central banks would be given a second policy instrument apart from interest rates. In some cases, for example if exchange rates deviated significantly from fundamentals, sterilised currency intervention might be such an instrument. However, despite the recent move by the Fed and the Bank of England to outright purchases of government bonds and risky assets, it is difficult to imagine central banks starting to intervene in various asset markets in order to correct perceived misalignments. For example, shorting the equity market or the housing market in order to stem a bubble would be difficult for any central bank to enact and justify. And moral suasion, i.e., pointing out asset price misalignments in speeches and publications, probably won’t do the trick on its own. Thus, if central banks want to influence asset prices, they will have to do it via interest rates in most cases.

Less predictable monetary policies... Whatever the precise approach in the future, asset prices are very likely to play a much bigger role in interest rate setting than they have so far. What are the implications? First, we think that policy may become less predictable, as inflation is no longer the only factor driving policy rates. This may not be as bad as it first seems: less predictable policy discourages excessive risk-taking. 

…and greater inflation variability. Second, inflation will likely become more volatile, since deviations from the target level will be more frequent, and last for longer: trying to pursue two targets (inflation and asset prices) with one instrument (the interest rate) will probably result in less accuracy on both fronts.

The more you care about asset prices... To illustrate this point, it is useful to compare the variability of inflation across countries where central banks have paid more or less attention to asset prices in the past. We show the coefficient of variation (the standard deviation divided by the mean) of headline CPI inflation, for the US, Euro Area, UK, Sweden and Japan. We use the coefficient of variation to compare inflation volatility rather than the simple average, because higher inflation tends to imply higher inflation volatility as well. The Fed has traditionally cared very little about asset prices (at least on the way up), while the ECB watched monetary aggregates, the evolution of which may yield information on current and future asset price misalignments. At the other end of the spectrum, the Bank of Japan, following the bursting of the asset bubble in the early 1990s, has cared about asset prices more than probably any other CB, frequently invoking ‘financial stability’ and buying and selling a wide array of assets. Sweden’s Riksbank has in the past justified interest rate increases while inflation was projected to be on or below target by mentioning rapid increases in house prices. Finally, the Bank of England is probably an intermediate case.

…the more your inflation rate varies. It turns out that the ranking of inflation volatility as measured by the coefficient of variation replicates the weight that these central banks seem to be placing on asset prices. Japan has had the highest inflation volatility (per unit of mean inflation), followed by Sweden. The US and the Euro Area have the smallest inflation volatility, with the UK in the middle. Granted, central bank preferences over asset prices are of course not the only driver of these inflation outcomes. But the results could still be indicative of what lies ahead.

Bottom line. The current post-bubble malaise makes it likely that central banks will pay more attention to asset prices and try to prevent or lean against bubbles when setting monetary policy in the future. If so, as asset prices and inflation don’t always move in the same direction, central banks may at times have to tolerate larger and/or longer deviations of inflation from target. But as the current crisis shows, this is a small price to pay in exchange for avoiding excessive boom-bust cycles in asset markets. 

Important Disclosure Information at the end of this Forum

Euroland
Bottom Fishing
April 03, 2009

By Elga Bartsch | London

Watching Out for Subtle Movements Below the Surface

Waiting for the signs of an economic turnaround to materialise sometimes feels a bit like being on a fishing trip. Like fishing, data-watching takes a good deal of patience. At the same time, you need to be constantly alert for anything interesting happening below the surface. Otherwise, one is bound to miss the very moment when the fish finally bites (the economy turns around). As far as the euro area economy is concerned, we are starting to see some interesting movements below the surface of what looks like a very grim flow of news and data. These subtle movements suggest that the moment at which the economy will show signs of turning around may no longer be that far off. Of course, we are mindful of the possibility of a false start. Hence, we would typically remain cautious until the uptrend in different leading indicators has established itself more firmly.

On the whole, businesses broadly reported a stabilisation in overall sentiment, if not a small improvement. Only Italy, where business confidence slipped further, seems to be an outlier compared to Germany, France and the Benelux countries. The incoming data, by and large, support our downwardly revised GDP forecast profile for this year. At this stage, the data point to another marked contraction in GDP in 1Q, followed by a gradual stabilisation over the summer and a timid recovery towards year-end. On the whole, this would likely leave combined Euroland 2009 GDP 3.3% below last year’s level. Next year, however, growth is likely to become positive again, we think, and GDP is likely to expand by 0.5%, on average.

We are particularly encouraged by our proprietary Surprise Gap Index moving into positive territory, suggesting that, for the first time since summer 2007, European corporates are positively surprised by how their business has developed. Similarly, we highlight that the forward-looking component of the German Ifo business climate, the business expectations for the next six months, has now improved for three consecutive months. These consistent gains over a three-month timeframe are important because, as a rule of thumb, we can view these gyrations as a new trend that has established itself with reasonable confidence, based on historical patterns. 

Current Production Starts to Stabilise Tentatively

After a very sharp decline over the last nine months, companies’ assessment of current production has tentatively stabilised in March. Current production in the euro area as a whole has recovered slightly over this period, but not enough to make a visible difference on its depressed low of 4.2 s.d. below its long-term average. The steady overall reading for the euro area (or, to be precise, the five large countries) masks some country differences: Germany and Belgium saw noticeable increases while Italy and France saw a small decline and the Netherlands a much bigger one.

Output Plans Continued to Recover

Having essentially bumped sideways at rock-bottom since December, output expectations recovered slightly to -4.3 s.d. in March. While we would not read too much into these numbers, we still find the sideways movement encouraging. Again, there are some noteworthy country differences, with Germany and the Netherlands reporting a significant upward revision and Italy a noticeably downward revision of output plans. Meanwhile, both France and Belgium reported no major changes in the near-term production outlook. Output plans continue to be way below order demand and inventory of finished goods, which are hovering around the -3 s.d. level. This gap underscores how aggressive companies have been in cutting back their production in the face of a demand slump.

Order Demand Still Falling, but at a Slower Rate

Order demand fell further to a new low of -2.9 s.d., but there is some indication that the rate of decline is slowing. In fact, all countries except Italy and the Netherlands saw a stabilisation in order demand during March. As before, the big gap between order demand and output plans suggests that companies have been very aggressive in cutting back production. Companies seem more content with the stocks of finished products than they were in December. That said, they still view inventories as being too high. Order books continue to show big country differences, ranging from -2.2 s.d. in Germany to - 4.4 s.d. in the Netherlands, suggesting that, despite very sharp falls, order books are still being better filled in Germany than in some of the neighbouring countries.

Our Surprise Gap Moves Back into Positive Territory

Our Surprise Gap, which captures whether companies are positively or negatively surprised about how their business has evolved compared to their own projections, has surged into positive territory in March, suggesting that companies are positively surprised for the first time since June 2007. Despite the sharp rise, the index narrowly missed the critical threshold for a statistically significant acceleration signal and instead still remained in the neutral range. As such, the Surprise Gap is not yet hinting at a turning point. But we hope that this will change in the coming months. Note that our Surprise Gap index is completely different from other surprise indices. While the latter tend to measure to what extent the recent data came in better or worse than consensus expectations, we try to estimate whether corporates themselves are positively or negatively surprised by how their own business is evolving. As the direction and the size of these surprises can potentially trigger changes in their decision on future production, orders and inventories, we deem this information to be highly pertinent to the near-term business cycle.

Our GDP Indicator Points to Deeper GDP Contraction

Since the autumn, we have observed a major discrepancy between our survey-based estimate of manufacturing production and the actual production dynamics in the industrial sector. In the current quarter, for instance, our manufacturing production indicator would point to a contraction of 3.1%Q, whereas carried-over growth of actual production up to and including January points to a slump of around 8%Q. Such big discrepancies are unprecedented for our models. The same holds for other indicators, such as the euro-coin indicator calculated by Banca d’Italia. As manufacturing production is a key ingredient of any coincident GDP estimates, our GDP indicator signals very different GDP dynamics, ranging from a highly optimistic 0.4%Q based on the surveys to -1.7%Q based on actual, albeit partial, production data. Both estimates are tracking above our official forecast of -1.9%Q (see Euroland Economics: An Even Deeper Recession, March 16, 2009).

Bottom line: While the euro area economy is currently trapped in the deepest recession since WWII, we still think that this sharp contraction in activity will eventually give way to a stabilisation in activity over the summer and a return to positive growth rates around year-end. In the meantime, we will be on the lookout for the first signs of improvement.

Important Disclosure Information at the end of this Forum

Global
The Morning After
April 03, 2009

By Spyros Andreopoulos & Joachim Fels | London

Bubble lessons. Central banks surveying the post-crisis landscape will undoubtedly sift the rubble for evidence of their own mistakes. The charge is well-known: by allowing money to be too easy for too long, central banks created an asset price bubble that has now burst, with familiar consequences (for an earlier version of the same charge, see J. Fels, Bubble Trouble, August 27, 2003).  For example, as we illustrate, both the Fed and the ECB kept real short rates well below their natural level over the 2002-05 period. Whether guilty as charged or not, the current crisis is likely to provoke a comprehensive rethink of the role of asset prices in monetary policy. What are the likely consequences, and how might central banks adjust their policies?

Traditionally, most central bankers have argued against targeting asset prices. The practical difficulties are such that a central bank could do more harm than good if it tried to prick bubbles (see, for example, ex Fed Governor Mishkin’s speech, Enterprise Risk Management and Mortgage Lending, at the Forecasters’ Club of New York, January 17, 2007). First, asset price bubbles are difficult to identify. At the very least, there is no reason to assume that a central bank would have better information than the markets themselves; but if the markets know that there is a bubble, then it would unravel automatically. Second, the central bank can always ‘mop up’ afterwards if a bubble bursts and there are deflationary consequences. Hence, no pre-emptive action is needed. Third, even if a bubble was reliably identified, monetary policy may not know the appropriate way, or have the appropriate instrument, to prick the bubble.

But the crisis strengthens the case for paying more attention to asset prices. Critics would respond that it is no more difficult to identify asset price bubbles than it is to identify potential output or the natural rate of interest, concepts that virtually all central banks use on a constant basis to conduct monetary policy (see Cecchetti, Genberg, Lipsky, Wadhwani, Asset Prices and Central Bank Policy, Geneva Reports on the World Economy, 2000).  It is also far from clear that markets would prevent bubbles from arising. Factors such as momentum chasing and costly arbitrage may exacerbate bubbles rather than containing them. Recent events – as well as less recent ones, such as Japan’s bubble – have probably discredited the ‘mopping up’ view: the fallout from the bubble may be so severe that it is difficult or even impossible to mop it all up. ‘Mopping up’ also creates moral hazard – the familiar Greenspan put. And pre-emptive action can be justified if preventing asset bubbles may contribute towards greater stability in the medium term – even if this entails a temporary departure from an inflation target. That is, emphasis should be on preventing bubbles from arising in the first place, rather than attempting to prick them once they are there. This would avoid the risk of plunging the economy into recession like the Fed did in 1929. Ironically, the recent crisis could help central banks justify greater short-term deviations from the inflation target with little loss of credibility. The deviations could be explained to the public as a price to pay in the short term in order to avoid repetition of crises, with all their traumatic consequences, in the future.

How to incorporate asset prices? Deciding to pay more attention to asset prices is easier said than done, of course. The real question is how to incorporate asset prices into monetary policy strategy. In principle, central banks are faced with three options:

•           Asset prices may be included in the price index that the central bank targets: This raises a host of questions: which asset prices should be included, and with what weight? For example, the inclusion of equities may be problematic, as all but a very small weight to equity prices may render the price index too volatile to be a meaningful target. House prices, on the other hand, are a more plausible candidate. In many countries, the CPI already includes some measure of housing costs, such as owner-equivalent rents (OER) in the US.  However, the correlation between actual house prices and OER has been fairly low during the surge in house prices. In Europe, by contrast, the HICP inflation measure still excludes the costs of owner-occupied housing.    

•           Watching asset prices closely and occasionally leaning against the wind if need be, without explicitly targeting a measure of inflation that includes asset prices: This may be a sensible strategy because asset price movements include useful information about future demand, and hence future inflation.

•           Watching money and credit aggregates and incorporating them into the monetary policy strategy: The rationale here is that asset price bubbles are usually preceded by strong growth in money and credit. The ECB’s ‘second pillar’ strategy goes in this direction – though with hindsight it could be argued that the ECB ignored the consequences of very strong money supply and credit growth for too long.

A second instrument apart from interest rates? Ideally, in order to target asset prices in addition to inflation, central banks would be given a second policy instrument apart from interest rates. In some cases, for example if exchange rates deviated significantly from fundamentals, sterilised currency intervention might be such an instrument. However, despite the recent move by the Fed and the Bank of England to outright purchases of government bonds and risky assets, it is difficult to imagine central banks starting to intervene in various asset markets in order to correct perceived misalignments. For example, shorting the equity market or the housing market in order to stem a bubble would be difficult for any central bank to enact and justify. And moral suasion, i.e., pointing out asset price misalignments in speeches and publications, probably won’t do the trick on its own. Thus, if central banks want to influence asset prices, they will have to do it via interest rates in most cases.

Less predictable monetary policies... Whatever the precise approach in the future, asset prices are very likely to play a much bigger role in interest rate setting than they have so far. What are the implications? First, we think that policy may become less predictable, as inflation is no longer the only factor driving policy rates. This may not be as bad as it first seems: less predictable policy discourages excessive risk-taking. 

…and greater inflation variability. Second, inflation will likely become more volatile, since deviations from the target level will be more frequent, and last for longer: trying to pursue two targets (inflation and asset prices) with one instrument (the interest rate) will probably result in less accuracy on both fronts.

The more you care about asset prices... To illustrate this point, it is useful to compare the variability of inflation across countries where central banks have paid more or less attention to asset prices in the past. We show the coefficient of variation (the standard deviation divided by the mean) of headline CPI inflation, for the US, Euro Area, UK, Sweden and Japan. We use the coefficient of variation to compare inflation volatility rather than the simple average, because higher inflation tends to imply higher inflation volatility as well. The Fed has traditionally cared very little about asset prices (at least on the way up), while the ECB watched monetary aggregates, the evolution of which may yield information on current and future asset price misalignments. At the other end of the spectrum, the Bank of Japan, following the bursting of the asset bubble in the early 1990s, has cared about asset prices more than probably any other CB, frequently invoking ‘financial stability’ and buying and selling a wide array of assets. Sweden’s Riksbank has in the past justified interest rate increases while inflation was projected to be on or below target by mentioning rapid increases in house prices. Finally, the Bank of England is probably an intermediate case.

…the more your inflation rate varies. It turns out that the ranking of inflation volatility as measured by the coefficient of variation replicates the weight that these central banks seem to be placing on asset prices. Japan has had the highest inflation volatility (per unit of mean inflation), followed by Sweden. The US and the Euro Area have the smallest inflation volatility, with the UK in the middle. Granted, central bank preferences over asset prices are of course not the only driver of these inflation outcomes. But the results could still be indicative of what lies ahead.

Bottom line. The current post-bubble malaise makes it likely that central banks will pay more attention to asset prices and try to prevent or lean against bubbles when setting monetary policy in the future. If so, as asset prices and inflation don’t always move in the same direction, central banks may at times have to tolerate larger and/or longer deviations of inflation from target. But as the current crisis shows, this is a small price to pay in exchange for avoiding excessive boom-bust cycles in asset markets. 

Important Disclosure Information at the end of this Forum

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