Stable Inflation versus Volatile Asset Prices: A Trade-off?
After the Great Inflation of the 1970s, central banks put a high premium on price-stability. William White argues that this paradigm is characterized by the four stylized facts:
1) a general reduction in both level and volatility of inflation;
2) robust and less volatile real economic growth interrupted by fewer recessions (both 1 and 2 referred to as “The Great Moderation”)
3) an increased prominence of credit, asset price and investment “boom and busts” often accompanied by financial crises of various types;
4) increased global trade imbalances.
Advocates of the current macro-financial policy framework emphasize the importance of a low inflation environment as a prerequisite for stable growth (Martin Wolf), as less disruptive policy responses are then required by monetary authorities to reign in cyclical bouts of inflation. They emphasize that a liberalized financial system in a low inflation environment allows for a welcome degree of intertemporal consumption smoothing in the household, corporate and public sectors. However, the increased asset price volatility requires a soundly regulated and well-capitalized banking system as a crucial ingredient to ensure financial stability (Frederic Mishkin). When these conditions are met external imbalances do not represent a priori a source of concern and central banks should not interfere with the asset allocation choices of market participants unless they threaten price stability either on the up- or downside (Alan Blinder).
Advocates of an alternative view such as William White argue that the focus on price stability alone is insufficient: a look back shows that the most extreme economic upsets in history stem from credit-fuelled investment booms at times of stable consumer price inflation. Paradoxically, as White argues, low price inflation can generate dangerous asset price bubbles. Of particular concern in his view is the incentive for debt accumulation due to low real interest rates. The resulting internal imbalances fuel the build-up of even harder to manage external imbalances and excessive asset price increases. The current central bank orthodoxy that it is better to addresss the economic consequences of bursting bubbles than to try to prevent them from building up adds an asymmetric tilt towards lower interest rates into the monetary system (Nouriel Roubini) – a tilt that gives rise to another round of credit-fueled boom/bust cycles.
White argues that the deficiencies of the current framework become apparent once nominal interest rates hit the zero bound or when real debt deflation sets in. In those cases, central bankers’ policy tools prove to be inadequate. Japan’s lost decade is an example. Ben Bernanke asserts that Japan was not able to generate positive inflation because of long-standing inefficiencies in the banking sector, not because of any technical infeasibility. White isn’t convinced and advocates for policy makers to focus on internal imbalances before they grow into intractable external liabilities. This includes not only asset price monitoring by central banks but also the prevention of unusually low domestic savings rates for instance, even if that results in a temporary recession. Edward Truman extends the recommendation for domestic demand and supply growth rebalancing to fiscal authorities as well, even at the cost of slower growth.
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