Caroline Baum says it’s time to reconsider the resistance to preemption – using monetary policy to pop bubbles before they get too big:

Central Banks Reconsider Doctrine of Preemption, by Caroline Baum,Bloomberg: It is an article of faith that central banks can’t identify an asset bubble ex ante; that they don’t have better knowledge of the appropriate level of asset prices than financial markets; that they can best serve the public by addressing the aftereffects of the bubble once it bursts.

With central banks around the world pulling out all the stops to keep money flowing, banking systems functioning and economies growing (or not sinking so much), perhaps a re- evaluation of the doctrine of preemption is in order. If central banks are willing to risk trillions of taxpayer dollars in their role as lender of last — make that only — resort, then an ounce of prevention may just be a better policy prescription. …

”Prevention (of asset bubbles) is the best way to minimize costs for society from a longer-term perspective,” said Otmar Issing, the former chief economist for the Deutsche Bundesbank and European Central Bank, in a Feb. 19, 2004, Wall Street Journal op-ed. ”Most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit.” …

The current crisis, which has witnessed the demise of venerable financial institutions and the intrusion of government into the private sector in ways not seen since the 1930s, is prompting many economists to reconsider the doctrine of preemption.

”I was always skeptical of the ability of the central bank to target asset prices,” [former Richmond Fed President Al] Broaddus… ”I haven’t given up that skepticism, but after an event of this magnitude, the Fed has an obligation to look at this.” …

Hindsight is easy. The goal is to find a framework so that policy makers can practice preventative, not curative, medicine.

In sticky price models, inflation is problematic, in part, because it distorts relative prices. Prices are reset with differing frequencies rather than continuously in these models, and as some prices are reset while other remain fixed, relative prices are distorted.

The goal of monetary policy is to eliminate these distortions as much as possible, that’s the best way to stabilize output and employment, and pursuit of that goal generally results in a Taylor rule type policy prescription that links the federal funds rate to deviations of output and (some measure of) inflation from their target rates.

I’m starting to think of these relative price distortions, which generate departures from long-run fundamentals, as bubbles – froth perhaps for prices that are only moderately sluggish in responding to shocks. From this perspective, if you accept the idea that these distortions are bubbles (you may not), the Fed already tries to pop bubbles, just not asset bubbles.

And it does this in an automatic way. How? By creating a price index where the individual prices that make up the index are weighted according to their rigidity (throwing out volatile prices like food and energy, or trimming out a certain percentage of volatile prices, can be viewed as an attempt to approximate this theoretical weighting scheme). This index is then monitored closely, and when it goes up, the federal funds rate is raised in response and tht has the effect of minimizing distortions. Thus, as prices begin to rise, because of a bubble or for other reasons, the Fed responds aggressively. In normal times, the federal funds rate is increased more than one-to-one with increases in inflation in an attempt to halt further price escalation.

[There is a similar argument regarding wage inflation based upon the same ideas – preventing distortions in labor markets – and the theoretical models indicate that an index of wage movements should also be part of the rate-setting decision. This is not done explicitly, but it is done implicitly since wage movements are an important factor in FOMC discussions.]

There is one set of prices, however, that theory says ought to be part of the rate-setting decision, but they are missing. And interestingly, and perhaps only coincidentally, the one set of prices that are not monitored and responded to just happen to be the place where bubbles erupt – asset prices. But if we include these prices in the Fed’s policy rule so that whenever asset prices rise the Fed responds by increasing the target interest rate, and if we weight the asset prices properly so that some prices, e.g. housing prices, receive more weight (house prices are notoriously sticky, so theory says they ought to receive a lot of weight), then perhaps it’s much less likely that a little bubble turns into a big bubble. Asset price inflation will be stopped by increases in the federal funds rate (and if it isn’t stopped by interest rate hikes, then other measures can be implemented). With this approach, you don’t have to debate whether a particular price run is a bubble or not, if it is creating asset price inflation, then there will be an automatic response of the federal funds rate to temper the increase. To me, not having to know if it is a bubble or not is an attractive feature.

If we didn’t identify one of the largest bubbles in memory, and for the most part people didn’t, I’m not confident we will be able to come to any kind of consensus about “ordinary” sized bubbles before it’s too late. And if that’s the case, waiting until are certain we are observing a bubble will delay policy beyond the point where it can be helpful. Instead of endlessly debating whether a particular price run is a bubble or not, and not having the argument settled until it pops and it’s too late to do anything about it, with this approach policy responds immediately to eliminate distortions.

Originally published on Oct 15, 2008 at The Economist’s View and reproduced here with the author’s permission.