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CENTRAL BANKS ON THE TRAIL OF THE MUTANT IFLATION MONSTER

Any central banker worth his salt knows what central banks are meant to do: aim for “price stability”. But stability of which prices? Are the ever higher prices being paid for “assets’ - most notably shares but also such things as Manhattan apart­ments, Beatles guitars and vintage wines - as damaging to economies as rapid in­creases in the average price of goods and services such as carrots, clothes and haircuts?

The question of whether central banks should worry about asset-price inflation as well as product-market inflation is cur­rently the subject of a lively debate - and one of pressing importance. Rising prices for assets usually do not figure in the con­sumer-price indices by which inflation is conventionally measured. Yet while these indicators show that inflation renfains sub­dued in developed economies, the prices of financial assets such as shares have been soaring

Central bankers have good reason to hate inflation. By distorting prices, it re­duces economic efficiency and therefore can harm growth. It is trickier to spot changes in relative prices if the general price level is rising rapidly. Businesses cannot tell whether rising copper prices, for example, reflect a scarcity of the metal or just a general inflationary trend. So resources are misallocated.

This argument is generally applied to the prices of goods and services for current consumption by households or businesses. But it surely also applies to the prices of claims on future goods and services, such as equities or prop­erty. Just as with product prices, rapid increases in asset prices can distort the allocation of resources. If a sharp rise in share prices reduces the cost of capital, for example, then firms will be tempted to overinvest. In addition, property-price booms lure in more investors, who are en­couraged to borrow heavily in order to bet on further price gains - a course which eventually ends in tears.

Indeed, the consequences of large in­creases in asset prices can be much more serious for economies than consumer-price inflation. Soaring share and property prices in Japan in the second half of the 1980s caused massive overinvestment in factories and machinery, and property. The consequent bursting of that bubble has been painful for the economy.

Central banks already look at asset mar­kets for advance signals about the strength of the economy, but there are two reasons why central banks might want to respond more directly to increases in asset prices.

*  The wealth effect. Higher asset prices can feed through into the prices of goods and services. Higher share prices boost house­hold wealth, which encourages consumers to spend more. A rise in share prices also makes it cheaper for firms to raise funds and so invest more. Meanwhile, the rise in the value of collateral, such as property, in­creases the willingness of banks to lend. All these things can swell domestic demand and so push up general price inflation. Likewise, a sharp fall in asset prices might push an economy into recession.      

*  Financial stability. If an unsustainable rise in asset prices goes into sharp reverse, this can trigger financial instability. Japan’s recent experience offers a painful example of how a collapse in share or property prices can harm a banking system.

Since pricking a financial bubble is a risky business, it is clearly better for cen­tral banks to step in early to prevent one developing. The tricky question is how to distinguish asset-price inflation - from a rise in share prices which reflects real fu­ture gains in company profits. It is un­likely that the doubling of American share prices over the past three years is fully justified by faster productivity growth and hence higher future profits.

Liquid refreshments

It is true that the growth of money in an in­dividual economy has long ceased to be a reliable compass by which to steer interest rates, but many economists believe that global money-supply growth is still a useful indicator. They argue that global “excess money” (broad money growth minus nom­inal GDP growth) is a handy gauge of liquid­ity which is available to invest in financial assets. This measure of liquidity is currently growing at its fastest rate for ten years.

Just as too much money in the real economy chasing too few goods causes goods-price inflation, so too much money in the financial sector chasing too few as­sets causes asset-price inflation. This theory dates back to Irving Fisher, an early 20^th-century economist. He believed that policy-makers should focus on a more broadly de­fined price index which includes asset prices. A rapid rise in this index would sig­nal the need for tighter policy.

But even if share prices are rising too rapidly, the ability of central bankers to dampen speculative excesses is con­strained. Central banks cannot pursue two goals - stable product prices and stable as­set prices - with interest rates alone. If a cen­tral bank tries to cap asset prices by raising interest rates when there is little sign of in­flation in the real economy, it could result in deflation in product markets. 

 History is instructive. There are two ex­amples of central banks acting to burst share-price bubbles. Both ended in tears. In the late 1920’s, the Fed was at hrst reluctant to focus on the stockmarket as a target of policy; when it did raise interest rates, Wall Street crashed in 1929. Likewise, the Bank of Japan was slow to respond to soaring as­set prices in the late 1980s, mainly because inflation remained below 2%; when it fi­nally did, markets crashed.

There is an awkard asymmetry in how central banks can respond to stockmarkets. It is politically much easier for them to slash interest rates quickly to support the economy after share prices have collapsed than it is to raise rates early to let some air out of a financial bubble. Far from being dead, inflation has taken on a new and more dangerous guise.

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