Submitted By Joseph Carson, Former Director of Global Economic Research, Alliance Bernstein
The Federal Reserve is facing the growing possibility of the third asset price bust in the last two decades. And each one has a "Made in Washington" label attached to it as policymakers have failed to use official rates to maintain financial stability while also inadvertently fueling excessive asset price gains by pursing expansionary policies to achieve their inflation-target.
At this time, policymakers are between a rock and hard place; if they decide to continue to raise official rates along the path they outlined asset prices are likely to fall further, albeit from record high levels, and if they decide to pause elevated asset price levels and associated financial balances will remain a big risk for the foreseeable future. In other words, it’s a "pay me now or pay me later" decision.
From Inflation Monitoring to Inflation Targeting
Inflation has always been a central focus of the Federal Reserve. Yet, it the past two decades the focus has shifted from monitoring and responding to economic and financial conditions that have the potential to create inflationary or disinflationary conditions to the management of hitting a single target for a narrowly defined basket of consumer goods and services.
For example, during an 8-year stretch, from the beginning of 1994 to the end of 2001, core consumer price inflation (the Fed’s main price target) never posted one year of over 3% or one year under 2%. Despite that relatively steady price environment the Federal Reserve moved official interest rates up and down a total of 31 times, 13 of which were more than 25 basis points, and most of the moves were not telegraphed ahead of time.
Over that period, official rates were moved in response to fast growth, slow growth, strong and weak trends in commodity prices, international crises, sharp moves in currencies, abrupt shift in credit market conditions and large and sustained gains and declines in equity prices. Few recall that monetary policy was effective when it was less transparent and used official rates to respond to a diverse set of economic and financial conditions.
The policy framework started to change in the early 2000s when policymakers wanted to secure and maintain the low and stable price environment. Policymakers started to embrace the inflation-targeting practices of other central banks as the best way to secure the current low inflation rate and to anchor expectations of future inflation.
Although it was not formally adopted until years later policymakers based many their policy decisions on hitting a specific target of 2% in the published price indices. During this period, policymakers saw no conflict between inflation targeting and the preservation of financial stability, although that was more of conjecture as there was not a sufficient body of evidence to prove otherwise.
The last two decades have clearly demonstrated that excessive increases in real and financial asset prices can occur without any significant movement in the standard price measures. Inflation is a monetary phenomenon and yet nowhere in the economic textbooks does it say that an accommodative monetary policy will cause inflation to only appear in the published price indices of the federal government.
Many questions remain unanswered, but the events of past two decades have rendered one clear answer in that asset price inflation has become a permanent feature of the transmission of the current monetary policy framework of inflation targeting. Policymakers need to rethink its framework, raising the importance of its third mandate financial stability, and be willing to use official rates to maintain financial stability, or asset cycles and financial crises will continue to be "Made in Washington."