The economic consequences of the Bernanke put

Should central banks take account of asset prices? This was until recently one of the most hotly debated subjects in monetary economics. As of this week, the issue has been effectively settled. Everybody now believes, or rather acts as if, they should. The two central banks that have been the loudest proponents of a policy to ignore asset prices, the Fed and the Bank of England, have both made spectacular U-Turns with a few days. They have both irgnored the bubble when it was inflating, but they now care deeply about it when it is deflating. This was not the way it was supposed to be, but it happened for reasons that are largely outside the control of the central banks.

The real tragedy of Mervyn King, the governor of the Bank of England, is that he really believed in the position that central banks should focus on inflation only, and provide only limited assistance to the financial sector, perhaps only to maintain the basic financial architecture, but never to bail out defaulting banks. But back in the real world, there are governments that need to be re-elected, and governments in general do not allow banks to fail. Central banks may be independent these days, but they are part of the body collectively known as government. Central bank independence is extremely limited, even in the euro area, and is mostly confined to monetary policy decisions.

 

History tells us that bank bailouts are the modern-day rule, not the exception. The US bailed out its savings and loan industry, the Germans bailed out IKB and SachenLB, the British bailed out Northern Rock. And the Fed has bailed out all of Wall Street with an interest rate cut that is evidently not consistent with its medium-term inflation objectives.

 

The Bank of England and the Treasury did the right thing. And so did the Treasury in the view of the sharp deceleration of the US economy. The German goverrnment, too, did the right thing, when it bailed out its banks. And so did the US when it bailed out the savings and loan industry. Our point is a different one. When you care deeply about asset prices – and the health of the financial sector in a wider sense - during a downturn, you have a moral obligation to care about both during an upturn. This does not mean that the central bank should prick bubbles. This is a mischievous way of phrasing the issue. But the central bank should take asset prices into account when formulating their policy. If the Fed had cared about asset prices, then it would never have cut the Fed Funds target rate to 1%, and kept it there for a year. In the UK, the inflation targeting central bank allowed an unsustainable house price boom on the spurious ground that it may be sustainable after all. 

 

The legacy of the inflation targeting central bank will be a series of asset price bubbles, and an ultimate inflation overshoot. Not much glory left.

 

 

 

Where now for the Fed, the ECB etc.?

 

The FT has reported that the rationale behind the Fed’s rate cut was to get all the pressure out of the way. To show bold leadership in the fight against the looming recession, without pre-committing itself to further rate cuts. Who are they kidding? Any experienced central banker, of which they are a few on the Fed’s board, can tell you that this game does not work. Once you play it, the markets have won. They demanded a 50 basis point cut, and this is exactly what they got. If the Fed had cut by 25 points, there would have been a severe sell-off in stock markets. The surveys of US economists already suggest that they expect another 50 basis point cut next time. Martin Feldstein said at Jackson Hole the Fed should cut by 100 points, and take greater risks with inflation than with growth. This is precisely what the Fed will do. Of course, as the US economy turns down, the Fed has much less manoeuvre this time than in 2001/2002. The only thing it can do is to use this room for manoeuvre as decisely and quickly as possible. I cannot see the Fed Funds rate go below 3.5 per cent at the bottom of the next rate cutting cycle. Anything less would get us into the territory where negative real interest rates would become probable, and foreign investors would be deeply unforgiving if this were to happen. Another 50 point cut would get us to 4.25%, already fairly close that limit. So this is as good as it gets. Enjoy this mini stock market boom while it last – in other words, this is great time to sell.

 

While we expect European interest rates not to go up from the current level of 4%, we do not expect them to fall either, at least not for now. This means that we are reversing from a situation where there was a US interest rate premium to a situation of nominal equality, except of course that inflation is well under control in the euro area, and much less so in the US. Expect the dollar to fall fiurther, perhaps much further, and of course US treasuries.

Eurointelligence ECB Watch

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