Activist monetary policy — specifically tightened policy — which has been employed in the past to limit emerging asset price bubbles, should not be the end-all-be-all option for central banks, Federal Reserve vice chairman Donald Kohn said Wednesday at the Cato Institute‘s annual Monetary Policy Conference. The two methods often employed in dealing with a possible asset price bubble are the “conventional” and the “extra action” strategies. “A central bank following the conventional strategy does not attempt to use monetary policy to influence the speculative component of asset prices,” because such an action will result in sub-optimal economic performance. “Instead, the central bank responds to asset price movements, whether driven by fundamentals or not, only to the degree that those movements have implications for future output and inflation.” The argument for a more activist policy has been that central banks should take extra action as soon as it perceives bubble development by tightening policy with the hope of limiting the size of the bubble and the eventual fallout from its deflation. “Such a strategy, if successful, could deliver substantial benefits, and a number of central bankers have talked about the need to consider a policy of extra action on occasion, and perhaps have even implemented such a strategy,” he said. “However, taking extra action also would entail some costs, such as creating, for a time, higher unemployment and lower inflation than would otherwise be desired.” This more aggressive strategy might be justified, according to Kohn, if three tough conditions were met. A major requirement would be the existence of a potential gain from limiting bubbles, he said. Kohn has spoken in the past of his concern regarding potential fallout from a housing market collapse, but he said the real costs have proven to be much greater. “I and other observers underestimated the potential for house prices to decline substantially, the degree to which such a decline would create difficulties for homeowners, and, most important, the vulnerability of the broader financial system to these events,” he said. Before policy makers could consider the potential gains, they’d have to first identify a developing asset price bubble in a timely manner, although this step might prove tricky because not all the fundamental factors driving asset prices are directly observable, according to Kohn’s statements. “Any judgment by a central bank that an asset is overpriced is by nature uncertain,” he said. Instead, central bankers should take caution in the face of such uncertainty. “Nonetheless, even if policymakers are confident that a bubble has emerged, the question of the timeliness of the call remains,” Kohn said. “The risk is that the detection and subsequent policy response occurs not long before the bubble collapses on its own,” so that any monetary tightening put into place would occur just as the adverse effects of the bubble’s collapse are being realized, worsening rather than mitigating its effects. The final requirement Kohn mentioned was an ability of monetary policy to check expansions in asset bubbles. While he acknowledged tighter policy might have succeeded in shifting down the path of house prices, he cautioned against making the leap that such action would have discouraged broader speculative developments that drove overly-optimistic expectations of price appreciation, excessive leveraging, and a marked increase in risk-taking by homeowners and investors. “I am not convinced that the events of the past few years and the current crisis demonstrate that central banks should switch to trying to check speculative activity through tighter monetary policy whenever they perceive a bubble forming,” he said in conclusion. “The recent experience may have made us a bit more confident about detecting bubbles, but it has not resolved the problem of doing so in a timely manner. Nor has it shown that small-to-modest policy actions will reliably and materially damp speculation.” Read his remarks. Write to Diana Golobay at [email protected].

More: