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21.01.2010

14:45 Uhr

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Shadow ECB Council discusses dangers of loose monetary policy

In preparation of their monthly meeting members of the Shadow ECB Council discuss risks from keeping rates too low for too long. Latest comment by: Julian Callow

Thomas Mayer

I think it is important to recognise that the costs of exiting the presently very easy monetary policy too late are at least as high as those of exiting too early. The latter consist of a return to recession, the former of an asset price bubble followed by inflation or deflation. I do not think that key asset markets are already again significantly overvalued (with a few exceptions, such as some real estate markets in Asia and the UK). However, this could change if rates were kept at present levels for a very long time with a view to forcing growth up and unemployment down. Some of those who agree with this assessment argue that intererst rate policy is too blunt an instrument to be used to lean against asset price inflation and point to regulation as a means to counter asset price bubbles. I would agree that counter-cyclical elements in the regulatory framework have an important role to play. However, I would caution against relying on regulation to dampen excessive risk appetite stimulated by super-easy monetary policy. It would be unfair to the regulators to assign to them the sole responsibility for preventing dangerous asset price bubbles. Interest rate policy has to shoulder part of the burden. If this bothers theoriticians of monetary policy, all the worse for these theoreticians.
Thomas Mayer is Chief Economist of Deutsche Bank

Erik Nielsen

I see very little probability of asset price bubbles (of dangerous proportions) or elevated inflation in the Euro-zone within the forecastable period, say the next 2 years. (If ECB policies contribute to asset price bubbles in other countries, e.g. in Asia, then the response to that should be that the ECB sets policy for the Euro-zone and others have the exchange rate with which to shelter themselves.) Beyond that its a matter of greater uncertainty, but there'll be time to address it if it looks to become a problem. So, the short answer to the question if anything can be done about it is "ye"s, if it were to be an issue there are plenty of things that can be done, but there is no need for such action at this time.
Erik type="person" value="? Nielsen, Erik">Nielsen is Chief European Economist of Goldman Sachs

Gustav Horn

The low rates have already contributed to the rise of asset prices . And that is what they are supposed to do. Rising share prices e.g. make it easier for firms to receive new equity. That helps to cope with the crisis. When a desired rise of asset prices turns into an undesired asset price bubble is diffcult to decide. It should not be the concern ot monetary policy but rather of proper regulation rules. If rules are appropriate they diminish the incentive to invest with rising prices. That should help to avoid bubbles. Presently these rules are not (yet) in place. Therefore the emergence of an asset price bubble cannot be excluded. However this does not mean we would be heading for inflation. .Inflation is a general rise of the aggregate price level beyond the target rate of a central bank . That will only happen in a booming economy when capacities are fully exploited and employment is high such firms can rise prices easily and employees s can fuel that rise demanding extensively high wages. In the foreseebable future such a situation can be excluded and thus inflation.
Gustav Horn is Scientific Director of IMK Institute

Jacques Cailloux

Perhaps the most important lesson from policymakers globally post financial crisis is that they will have to take a more pro active approach to tackle asset price bubbles. Assuming, and it is a big if, that the central bank could identify the formation of asset price bubbles, it could in principle “lean against the wind”, making the cost of money higher than would be warranted based solely on the outlook for growth and inflation. While there is some merit in this approach, the most powerful counter argument stems from recent academic research which shows that asset prices tend to react with different lags to a monetary policy shock. For example, in a study covering 17 OECD countries, Wesche and Gerlach (2008) find that equity prices typically respond instantaneously to a rate increase, while property prices only respond gradually taking more than 2 years to stabilise. Consumer prices respond with a considerable lag, typically two years after the policy response. The conclusion from this analysis is that using a single policy tool to target different asset prices, looks overly ambitious and likely fraught with danger. The most promising avenue for reform is through the macro prudential framework, first by eliminating the procyclicality that had been introduced through Basel II and second by actually implementing counter cyclical measures, through capital requirements or dynamic provisioning.
Jacques Cailloux is Chief-European Economist of Royal Bank of Scotland

Marie Diron

At the moment, I do not think that the monetary policy stance is likely to create an asset price bubble or to generate high inflation. Asset prices in the euro area have risen significantly from their trough but do not seem overvalued. Moreover, asset prices do not evolve in a sphere of their own. They will continue rising significantly only if growth also rises to much higher levels than the current ones. At which point, it will be time to tighten monetary policy of course. So while keeping interest rates at current levels for too long would risk inflating asset prices beyond what is justified by fundamentals, we are still far enough from such a danger zone for the ECB to act.
Marie Diron is Senior Economist at Oxford Economics

Charles Wyplosz

Given the existing and foreseen (by those who make forecasts) output gaps, I see no inflation threat and no need to worry about interest rates. Onthe other hand, since banks claim that they are in good shape - which I don't quite believe, maybe because for once I am a pessimist - it is time for the ECB to start withdrawing its quantitative easing. No need to subsidize banks any more. If some fail, they will have been proven liars and, while the consequence for the economy could be very unfortunate, there is no better way to remove the uncertainty since stress tests seem impossible in Europe. For ten years, the consensus view was asset prices are of no concern to central banks, which was silly all along. Now the consensus is rushing to the polar view that asset price inflation is round the corner and that interest rates must be raised, even though unemployment is still rising. I expect this view to be proven as silly as the previous one, although with less dire consequences.

I submit two propositions.

The first one is controversial. It is that monetary policy (interest rates too low for too long) did not create the bubbles that we saw, even though I would concede that it may have exacerbated the problem. That our US colleagues develop this view is comprehensible, but not in Europe. The same low interest rates prevailed (for a limited period) in the euro area. Housing prices exploded in Ireland, Spain and a bit less in France, while they stagnated or declined in Germany and Austria. Same cause, different effects? Yes, because the true problems concerned the regulation of credit and the functioning of housing markets. Where regulation was adequate, low interest rates did not create bubbles. So, please, don't balme them for the past and don't blame them for the future.

The second is, I am afraid, in line with the conventional wisdom among central bankers. Central banks must worry about bubbles, they should blow the whistle when they see one, but they should not raise the interest rate. Saying that the interest rate is too blunt is correct, but misguiding. A fundamental principle of public economic interventions - aka the second best theory - is that they are justified when, and only when, a market failure is identified and, in that case, the intervention should target the failure as directly as possible. My point above is that the housing price bubbles resulted from credit and/or housing price market imperfections and inadequate regulatory responses. The solution should have been to deal with these regulatory failures, not to raise the interest rate. In 2000, the Nasdaq collapse resulted from unrealistic market expectations. The solutions should have been to quiet down the markets, for example with an ad hoc tax. If bubbles arise in the future, the same logic should apply. The role of the central banks should be to identify the bubble and call upon the government do its job, and very publicly so. The interest rate is not a second-best response and it could well be an nth best response with n very large.

Marco Annunziata

The outlook for growth and inflation suggests there is no hurry to tighten monetary policy, and I think the risk of asset price bubbles for now is limited. Monetary tightening now would therefore be premature. However, exceptionally supportive monetary policy should not become a durable substitute for other policy actions needed to speed up the economic and financial normalization. To be precise: the last 1-year Long Term Refinancing Operation suggests that parts of the banking sector are still highly dependent on ECB liquidity; and recent developments in Greece underscore that some governments might find it harder to finance themselves if ECB liquidity were drained to any significant extent. These are factors that could cause monetary policy to be severely constrained even once the macroeconomic outlook improves in more sustained way. Similarly, unless structural reforms are quickly accelerated, the growth outlook could remain precarious for reasons that have little to do with the monetary policy stance. Based simply on the “single needle” of inflation, both the Governing Council and the Shadow Council could take a very extended holiday and reconvene sometime in 2011. There is a risk, however, that the economic, financial and political systems become addicted to an exceptionally supportive monetary stance that was designed in response to an emergency—I have a good deal of sympathy for the view that we should not underestimate the attendant risks, some of which we will probably be unable to foresee. True, there are more targeted instruments to try and prevent asset price bubbles, and they should be deployed. But loose global monetary policy, often under the cover of central bankers’ self-congratulatory speeches about the “Great Moderation”, has no doubt played a role in the last crisis and could again create serious distortions. We should therefore balance carefully the risks of tightening too late vs those of tightening too soon.
Marco Annunziata is Chief Economist of Unicredit

Jean-Michel Six

The current low rate environment creates risks of asset price bubbles primarily in emerging markets. The typical case would be investors borrowing at zero interest rates in USD and invest in high yielding currencies such as the Russian Ruble. But such risks lay well outside the eurozone where the tepid recovery will keep inflation expectations very low. Other eurozone asset classes, such as stocks and commercial property have seen some recovery after the severe beating of early 2008, but are in no way presenting signs of a bubble. In fact the real risk in 2010 affecting investors and private sector borrowers in 2010 in the eurozone is in the opposite direction: after a very successful year 2009, bond markets globally and hence in the single currency zone as well are likely to experience a new situation where bond supply significantly exceeds demand. This is because a strong proportion of bond demand in 2009 came from the central banks (quantitative easing for the Fed and the BOE, recycling of FX reserves for EM central banks), who represented an estimated 35% of total demand. Commercial banks, incentivized by the new regulations (Basle II..) to buy ionvestment grade bonds represented another 20% of total demand. In 2010, while the supply of bonds , in particular by Sovereign issuers, will continue to rise, demand will contract as central banks progressively exit their accommodative strategies. Supply is therefore likely to exceed demand causing yields to rise and prices to fall, i.e. a bust rather than a bubble. A recovery in bank lending could to a certain extent compensate the negative effects of such developments on private sector borrowers, but the new regulatory environment in the eurozone makes such an occurrence less likely.
Jean-Michel Six is Chief European Economist of Standard & Poor's

Agnès Bénassy-Quéré

I think that the strategy developed by the ECB is correct so far as it can be reversed in the case there would be a new liquidity bottleneck. The question of asset-price bubbles should be delt with by governments. If the Eurogroup thinks that share prices have grown too fast, why not tax capital gains? This would be a nice way of showing that they are determined to open a new era of coordination, and to start reducing deficits. Meanwhile, the ECB is correct not to commit to keeping constant interest rates over a (too) long period.
Agnès Bénassy-Quéré is Director of CEPII

Elga Bartsch

I agree with Thomas (and various ECB officials) that the costs of exiting too late are as serious as the costs of exiting too early. Thus, I would be against introducing a systematic bias into the ECB’s policy decisions, e.g. like the one that IMF favours. At this stage, I am not worried about creating new asset price bubbles though. This is because the ultra-low interest rates and generous liquidity provision by the ECB do not seem to feed into strong money and credit growth yet. On the contrary, except for the bloated narrow M1 aggregate, most other indicators are hitting record lows at the moment. However, I believe that the bubble question is setting too high a hurdle for policy action as it invariably requires forming a view on what fair value for a variety of asset prices is. In my view, the prospect of contributing to another boom-bust phase in asset markets would suffice to justify preventive policy action. Of course, this is not just a matter of the level of interest rates but also of the amount of liquidity provided. Also, it is not just about potentially creating an inflation problem in the future. When ultra-low interest rates are used prevent market exit of bankrupt companies, an extended period of the extra-expansionary monetary policy – as the example of Japan shows can -- also reinforce deflationary pressures. In Europe, this scenario is somewhat less likely because of the Single Market rules and the role of the EU Commission. That said, the consequence of allowing a built-up of excess liquidity is that extreme inflation outcomes become more likely than they normally would be. Hence, all monetary data need to be scrutinised carefully in the months ahead.
Elga Bartsch is Chief European Economist of Morgan Stanley

Angel Ubide

I agree with Charles that there is a bubble about bubbles at the moment - policy makers and analysts seem to see bubbles everywhere, and that just cant be true. So let's ban the word bubble, and talk about asset prices and monetary policy. The current setting of policy is a suboptimal one: fiscal policy did not do the complete task of removing the bad assets from banks' balance sheets and recapitalizing banks, and thus monetary policy had to be set at a very loose level in order to contribute to the healing of the banking sector. So we have the current policy setting, targeted at cushioning the downside risk posed by a potential credit crunch and the limits of the zero bound. How should moneary policy react if it feels that the impact of its policy setting, while appropriate from an inflation/growth standpoint, may be leading to asset price constellations that coudl become risky in the future - which I don;t think to be the case at the moment, by the way. Monetary policy has three instruments: the level of rates, the communication about the future path of rates, and the risk and maturity of the liquidity operations. If asset prices start overheating, then monetary policy can tighten by tightening the liquidity operations and by reducing the certainty about the future path of rates. Carry trades happen when there is certainty about the future. Increasing this uncertainty will lead to higher risk premia and temper asset price appreciation if needed, while allowing the level of rates to stay constant to best match the inflation/growth outlook.
Angel Ubide is Chief Economist of Tudor Investment Corporation

Julian Callow

Yes it is likely that the current ultra-low environment will create some additional volatility While policymakers have very successfully stabilised the economy, there is no guarantee that policy errors will be avoided on the exit. Moreover, by focusing on maintaining stable inflation expectations, it is inevitable that this will lead to major relative price shifts at a time when there is still major economic slack. We should be prepared for ongoing strength in commodity prices to result, which may look to some like an asset price bubble. As the economies then recover, there will be a growing danger that this will tip over into inflation expectations.In determining monetary policy, central banks need a clear inflation objective (given their one instrument), but in my view it should be a multi-year objective, not just for a fixed period ahead. That way the central bank can be required to pay attention to financial stability risks in terms of how this could impact the determination of a stable multi-year objective for inflation.As well, for sure CPIs should include a measure of home occupany costs, since this is a large part of expenditure.

Finally, it is very important that the basics of financial regulation are adhered to and that the lessons of the past are not forgotten (for example, in making prudent loan to income ratios, in ensuring adequate bank liquidity duration). This means that, if they are not formally responsible for bank regulation, central banks need to have strong financial stability departments which have a mandate to advise governments and regulators. Central banks themselves cannot be expected to bear the burden of responsibility for financial stability with just their monetary policy if this is not being adequately undertaken by the regulators.
Julian Callow is Chief European Economist of Barclays Capital

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