Monetary Policy Objectives and Measures regarding Asset Prices

In medieval Europe financial institutions issued their own banknotes, each denominated in the respective currency of the bank. With the establishment of central banks starting in the  17th century  with  the  Bank of  Amsterdam,  not  only  the  usage  of  deposit  money  became  popular, but also the supply of money was centralized.

Nowadays the Fed, the ECB, and other central banks issue currencies, which possess the status of a legal tender. These banks are thus the only suppliers of the liabilities (the monetary base), which commercial banks in turn need as legally required minimum reserves, as balances for settling interbank  claims,  and,  through the  fractional  reserve  system  and  the  resulting monetary multiplier, the central bank can thus control the entire money supply. This ability puts the monetary authorities into a very important position for achieving specific macroeconomic goals.

For most central banks the main objective is to maintain price stability. The reason for this lies in the well documented positive relationship between money growth and the price level  in  the  long  term. According to  Goodhart (1994) other important  goals  of  monetary authorities  are  sustaining  high  employment and  economic  activity,  reducing  interest  and exchange rate variability, and maintaining systemic stability of financial markets. However, target conflicts can emerge when central banks try to reach several goals simultaneously. In the last decades macroeconomic literature discussed very extensively the relationship between unemployment and inflation. Thereby the contributions of Phillips (1958), who was one of the first to discover a reverse interdependence, and Lucas (1976), who criticized the exclusion of expectation in the adapted econometric models, had huge influence in their field. Recently, due to the growing complexity of financial markets, the role of monetary policy to ensure the stability of financial markets and the interaction with other objectives became a prominent field of research and discussions.

In  the  view  of  Bernanke  and  Gertler  (2001,  p.14)  “central  banks  can  and  should  treat price stability and financial stability as consistent and mutually reinforcing objectives.” That seems to be true for the long term, since only sound financial markets can provide a steady state process of moderate volatility and economic activity, while systemic distress and even a following banking crisis and credit crunch can lead to a deflationary spiral. At the end, this can  even  be  more  harmful  to  the  goal  of  price  stability  than temporary  inflation,  because central banks then face a situation called liquidity trap, in which interest rates touch the zero lower bound  and  ordinary  monetary  policy  measures  lose  its  potency  to  steer  the economy  (see Keynes, 1937).

In the short run however, the relationship between the goal of price stability and financial stability, which includes sustainable developments of asset prices, is not so clear, especially in times of booming markets. (see Issing, 2008). This issue was also addressed by Alan Greenspan during a debate that took place inside the FOMC on September 24, 1996:

"What is really needed to keep stock market bubbles from occurring is a lot of
product price inflation. There is a clear trade-off, if monetary policy succeeds in one,
it fails in the other. Now, unless we have the capability of playing in between and
managing to know exactly when to push a little here and to pull a little there, it is not
obvious to me that there is a simple set of monetary policy solutions that
deflate the bubble."

After this speech, between early 1998 through February 2000, the Internet sector earned over 1,000 percent returns on its public equity. That the Fed did not react and did not increase interest rates earlier was criticized among others by Roubini (2006). He accused the Federal Reserve of not having neither “pricked” the stock market bubble in 1997, nor when the “evidence was obvious” in 1998-99. He also criticized the passivity of the central bank in the uprising housing price bubble. Also White (2009) supported an intervention of monetary policy in price misalignments in addition to a tighter collaboration with regulators to encounter the procyclicality of financial markets. The author stressed that the so called “Greenspan Put” led to moral hazard and encourage higher risk taking, since policy makers were inactive during the boost of asset prices (see also Florio, 2006).

Other supporters of “leaning against the wind of asset prices” among others were Cecchetti et al. (2000). By using the new-Keynesian framework, they found that during a rising bubble, optimal monetary policy should be tighter than a simple Taylor rule would suggest, while the opposite would be true for the time when the bubble bursts.

However, using a similar type of model, Bernanke and Gertler (2000, 2001) suggested that asset prices should not be targeted directly. In their opinion, a concentration on expected inflation leads to optimal outcomes. In both papers the authors adapted a New-Keynesian model and incorporated informational frictions in credit markets. In Bernanke and Gertler (2001) the authors criticized Cecchetti et al. (2000) that their procedure would yield a truly optimal policy only if (i) the boom is driven by non-fundamentals and the central bank knows about it and (ii) it also knows exactly when the bubble bursts. Thus Bernanke and Gertler recommended rather a “cleaning after the bust” than a “leaning against the wind”

Another contradiction of the latter theory is Posen (2006). One of the authors’ central arguments is that the “lack of effectiveness of monetary tightening to pop bubbles or to respond to financial fragility, and the far greater cost of inducing recessions than riding bubbles out, are structural factors characteristic of modern financial systems and of bubbles.” That is why “the cost–benefit analysis inherently goes against popping bubbles and in favor of monetary easing after busts.” (Posen 2006, p.121). This argument shows that it is crucial to know not only the impact of monetary policy on the economic activity and aggregated demand in general, but also on specific asset classes. Since every asset class reacts differently, it is important to know about these effects when the monetary transmission mechanism is to be investigated and optimal monetary policy is to be conducted.

Apparently, whether monetary policy should “lean against the wind of  asset prices” or “clean after the bust” depends particularly on the size of the effect that it has on asset prices. If no impact existed, then the pricking of the bubble would not be possible anyway. Otherwise, if interest rate policy had a huge influence, then a “leaning against the wind” would be more effective and relatively cheap. This work contributes to the discussion insofar that it provides, as one of the first studies, the quantitative methodology and estimations for the European market, which in turn are needed to conduct a reliable and reasonable response of monetary policy.

The reader should be aware that several other extraordinary policy measures exist, which are not covered by this analysis. These can consist of the following: Granting direct long term loans (credit easing), buying government or covered bonds (quantitative easing), decisions about the eligibility of securities for secured borrowing from the ECB, changes in the minimum reserve requirements for banks, the status of lender of last resort, and management of expectations in general. All these measures affect asset prices, depending on its type and its magnitude. Since a lot of these policy tools have been applied in the aftermath of the Lehman collapse in 2008/09, I exclude this period from the examination, to be sure that only the effect of interest rate changes is measured, as shown in section 5 of my diploma thesis.

Wie des Teufels Werk

Makroökonomische Zusammenhänge sind nichts anderes als monetäre Kreisläufe. Sie bestehen nicht nur aus Geld (also liquiden Mitteln) sondern auch aus Termingeschäften, nämlich den Schulden und deren Einforderungen. Durch diese Schuldverhältnisse begeben sich Haushalte, Unternehmen (allen voran Banken) und Staaten in ein gegenseitiges Abhängigkeitsverhältnis. Wobei die eigene Zahlungsfähigkeit von der Zahlungsfähigkeit der eigenen Schuldner abhängt. Wenn einer nicht zahlt, verzögert sich dadurch die Zahlung an den nächsten Gläubiger.

Diese Kreisläufe sind oft geprägt durch sich gegenseitig verstärkende Effekte. Dies kann in positiver wie auch in negativer Richtung wirken. Ein grundlegendes Beispiel ist der Keynesianische Ausgabenmultiplikator, der in jedem Wirtschaftsstudium behandelt wird. In dem Modell sind die Konsumausgaben und die gesamtwirtschaftliche Produktion in ein sich gegenseitig verstärkendes Verhältnis gesetzt, was dazu führt, dass der Staat in einer Abschwungphase den Konsum stärken sollte. Wenn die öffentliche Haushaltsposition aber schon vorher angespannt ist, sieht die Regierung sich aber vielleicht gezwungen zu sparen, was die Krise noch weiter verschärft.

Die beschrieben Wechselwirkung ist der "Teufelskreislauf" zwischen Staatsschuldenkrise und Makroökonomischer Krise rechts unten in der Abbildung. Zu der Staatsschuldenkrise in Europa existiert jedoch aktuell auch noch eine Bankenkrise, welche wiederum Wechselwirkungen mit den beiden anderen Krisen besitzt. Die Frage, welche Krise nun der entscheidende Auslöser für die anderen Probleme war, ist schwer zu beantworten und sicherlich auch für jedes Land individuell zu analysieren. Diese Schwierigkeit zeigt aber, wie eng die jeweiligen makroökonomischen Probleme miteinander verwoben sind. Nicht nur eine bilaterale Abhängigkeit lässt sich in dem Schaubild erkennen. Im Falle Spaniens und Irlands ist vor allem der kausale Zusammenhang gegen den Uhrzeigersinn von größter Bedeutung.