Compare and contrast:
Some observers have been arguing that our patience should be wearing thin sooner rather than later. One argument is that policy is very accommodative by historical standards and that many of the reasons for adopting such an accommodative policy no longer pertain. Demand has strengthened substantially, and the threat of pernicious deflation has receded. A second concern is that policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of this distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand…
I believe that at least for a while the macro imperatives are likely to outweigh any threat to financial or longer-term economic stability from accommodative policy. Any unusual distortions in asset prices that might intensify a subsequent correction are probably small…In our situation, a high burden of proof would seem to be on policies that would slow the expansion, leaving more slack and less inflation in the economy in the intermediate run to avoid hypothetical instabilities later.
–Donald Kohn, Vice Chairman of the Federal Reserve, March 16 2004
With…
There is a danger associated with the temporary, yet potentially extended period where low interest rates are needed to stimulate investment and consumption. With real interest rates below potential growth, private agents may just borrow to purchase assets in limited or rigid supply (e.g. real estate property). In this dynamically inefficient world with structurally weak growth prospects, this may actually become an attractive way for savers to generate returns on their savings that investments in the productive sector are unable to generate.
In this case, we end up with a “rational bubble”, which – as you will have noticed – follows the dynamics prominently highlighted by Jean Tirole. While unconventional monetary policy is not a necessary condition for this type of bubble to emerge, it may render it more likely – and more violent in the event of its materialising.
So what are the consequences of such bubble? In the short-term, it may indeed generate a temporary boost to the economy. And for a while this boost would be difficult to distinguish from the regular workings of asset purchase programmes, which actually embed asset price increases as a desired effect, which passes on the initial impulse to broader financing conditions via portfolio rebalancing.
But this boost would ultimately be very costly. Not only does it does it come with welfare-decreasing macroeconomic instability, but it also brings about an arbitrary redistribution of wealth that may, in the worst case, undermine social cohesion and trust that the central bank is acting within its narrow price stability mandate. And moreover, it can create financial stability risks elsewhere, generating negative spillovers from what should otherwise be a normal international adjustment process.
Against this background, it would be wrong to treat bubbles as a welcome replacement therapy to a sustainable growth model. Instead, macroeconomic and structural policies have to set the necessary conditions so that investment in productive sectors becomes attractive again and investment in bubble-prone areas is discouraged, so that total factor productivity is increased and the natural rate of interest ultimately reverts to what is normal.
–Benoît Cœuré, Member of the Executive Board of the European Central Bank, May 12, 2015
Whether the difference in rhetoric actually leads to different policy choices is less obvious. We also wonder what “macroeconomic and structural policies” Cœuré has in mind that would boost the attractiveness of investment in productive sectors while discouraging capital from bidding up real estate. Still, it’s encouraging that some of today’s central bankers at least appear to think recent experience merits a review of old assumptions.
Related links:
What’s the right rate? Or, the case for monetary policy nihilism — FT Alphaville
Central bankers are either too arrogant or too humble — FT Alphaville
Is the only choice bubbles or recession? — Bloomberg View
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