Monetary policy make-over

Dear all—

I’m about to take a break for a couple of months, maybe three, to accommodate my summer vacation, a work trip to Asia and a personal project I’ve just begun. But before I say “au revoir”, I wanted to leave you with the following thought…

There is something inherently counterintuitive, if not absurd, in the perception that a 1% increase in the inflation of my flower-pot is more damaging than the enormous swings we have all just experienced in the value of our wealth.

Translating the above into wonk-speak, if there is one major shake-up that this financial crisis should bring about, it is, in my opinion, the re-thinking of monetary policy as we know it… including the role of asset prices in the framing of policy rules and objectives.

To be sure, there have been plenty of papers arguing why asset prices should NOT be the direct focus of policy-makers (rather, an indirect objective, to the extent that they influence the prices of goods and services)—including by our Fed Chairman himself.

But I find these arguments wanting… To start with, they tend to rest on assumptions that have not been conclusively determined by economists (such as the size of wealth effects on consumption); or, they posit an asset bubble process that is exogenous, including to the policy tool itself (admittedly, the latter more reflects economists’ ignorance/ disagreement on how bubbles are formed).

But beyond these “small-scale” criticisms, the most important weakness I see has to do with what is currently a “consensus” about the objective of monetary policy itself. Unless one begins to rethink what monetary policy should be about, and what it should target, the arguments for or against asset-price targeting become frustratingly circular.

I’ll have more to say about this when I’m back.
So.. au revoir in the Fall!