More to it than just 'leaning against the wind'
Lars Heikensten | Wednesday, 4 June 2008
IN recent months the debate about monetary policy and asset prices has intensified again. This should be no surprise given the deep financial problems affecting in particular the US. However, the issue is certainly not new. In the world of central banking hardly anything has been discussed more during the past 10 years. The problems we are confronted with are a consequence not of lack of awareness but of the fundamentally difficult issues involved when trying to integrate asset prices into frameworks for monetary policy.
Inflation targeting has, in my interpretation, never been only about inflation. At Sweden's Riksbank we - like most other inflation-targeting central banks - always looked at the real economy. We also closely followed financial developments, partly because this was the lesson we drew from the country's deep financial crisis in the early 1990s. We made clear that we would be prepared to act if we saw serious problems building up. Interest rates might need to be raised to limit the risks of a future financial crisis, with severe real consequences.
In this sense we differed from some other central banks: we were explicit that we would factor in asset price developments when taking decisions if we thought them drastic enough to pose risks for the economy in the future. But, in arguing this way, I believe we were loyal to the so-called risk management approach to monetary policy. Alan Greenspan, former chairman of the US Federal Reserve, characterised this as "understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks".
In practical terms this implied that we followed closely the developments of equity prices in the late 1990s to check if they posed risks to the financial sector and real economy. The majority of the Riksbank board never thought action was required. Systemic risks for the banks seemed low. Also we believed that equity prices on the whole were set on the global market, where the impact from our actions would at best be marginal.
The case has been somewhat different since 2003. With house prices increasing drastically, risks for the real economy have been perceived to be bigger. On a few occasions in 2004-05 the Riksbank did for that reason not follow a strict inflation-targeting rule. We "leaned against the wind", in the sense that we did not take rates down as quickly as we could have done considering the outlook for inflation alone.
In discussions lately it has been common to argue that central banks would be better off combining an inflation target with a target for some monetary aggregate. This is thought to help in dealing with asset prices. The argument would be valid if the links between wide measures of money and credit on the one hand and asset prices on the other were clear, stable and operational, but they are not. Hence it is in my opinion much better to stick to your inflation target and explain clearly when you see reasons to diverge. This is exactly what we tried to do.
Wolfgang M
Inflation targeting has, in my interpretation, never been only about inflation. At Sweden's Riksbank we - like most other inflation-targeting central banks - always looked at the real economy. We also closely followed financial developments, partly because this was the lesson we drew from the country's deep financial crisis in the early 1990s. We made clear that we would be prepared to act if we saw serious problems building up. Interest rates might need to be raised to limit the risks of a future financial crisis, with severe real consequences.
In this sense we differed from some other central banks: we were explicit that we would factor in asset price developments when taking decisions if we thought them drastic enough to pose risks for the economy in the future. But, in arguing this way, I believe we were loyal to the so-called risk management approach to monetary policy. Alan Greenspan, former chairman of the US Federal Reserve, characterised this as "understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks".
In practical terms this implied that we followed closely the developments of equity prices in the late 1990s to check if they posed risks to the financial sector and real economy. The majority of the Riksbank board never thought action was required. Systemic risks for the banks seemed low. Also we believed that equity prices on the whole were set on the global market, where the impact from our actions would at best be marginal.
The case has been somewhat different since 2003. With house prices increasing drastically, risks for the real economy have been perceived to be bigger. On a few occasions in 2004-05 the Riksbank did for that reason not follow a strict inflation-targeting rule. We "leaned against the wind", in the sense that we did not take rates down as quickly as we could have done considering the outlook for inflation alone.
In discussions lately it has been common to argue that central banks would be better off combining an inflation target with a target for some monetary aggregate. This is thought to help in dealing with asset prices. The argument would be valid if the links between wide measures of money and credit on the one hand and asset prices on the other were clear, stable and operational, but they are not. Hence it is in my opinion much better to stick to your inflation target and explain clearly when you see reasons to diverge. This is exactly what we tried to do.
Wolfgang M