One instrument, one target

Am I the only person left that believes in this rule of thumb?  From a Herald article on the IMF:

Policy makers will need to employ judgment to look at what is driving asset price movements and discretion to avoid costly policy mistakes

Now to be fair, they also suggest that maybe central banks should have some other tools than just the interest rate.  But the fact is that, for now, they don’t.  Banks should not be targeting asset prices with interest rates at the same time as they are targeting inflation – its a recipe for policy failure.

Sure, use prudential regulation and try to deal with information issues in financial markets and the such to try and ensure that people face more of the risk regarding their own actions.  But don’t use the interest rates to attack asset prices.

There is no discretion here.  The central bank is trying to hold inflation at a target level given their interest rate tool.  Just do that.  It is mechanical, yes.  It is boring, yes.  It will not prevent crises, yes.  It is best policy, yes.

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  • Andrew Coleman

    Two comments, Matt.

    First, central banking with fiat money was invented to target asset prices – in particular to prevent liquidity crises in the banking sector from turning into collapses in asset prices so disastrous they led to nasty recessions. By providing cash to banks in exchange for their assets/loans in times of bank runs, central banks can prevent destabilising runs and support asset prices, something that cannot be done so well with a commodity currency. The only problem is that a fiat currency is susceptible to inflation….as central bankers around the world and in New Zealand have proved time and time again.

    The interesting question is whether central bankers should also try and prevent upward spikes in asset prices, as well as downward spikes, their raison d’etre, while at the same time not creating inflation. It doesn’t seem unreasonable to at least think about this issue.

    Secondly, there is at least one sense that central bankers have more than one instrument: they can simultaneously affect today’s spot interest rates and today’s forward interest rates, or, equivalently, they can affect the position and slope of the whole yield curve. That is quite a lot of instruments. From a logical point of view, it is possible that different shapes and positions of the yield curve can affect more than one target at a time (eg inflation and asset prices). If we had a clever and credible central banker, it might be possible to change the current OCR and talk about the future path of the OCR in a manner that both prevented inflation and prevented asset price bubbles or collapses.
    Mind you, one would need a lot of faith in the ability of central bankers to fine tune the economy to want to go down this path, faith that past experience does not necessarily inculcate.

    Perhaps you are right and central bankers should just try not to debase the currency by another 15% in the next six years. That at least would be consistent with the legally-required-but-not-enforced objective of price stability.

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