Fed Needs to Include Asset Prices in Their Playbook

In 2008 I attended the Federal Reserve Bank of Boston 52nd annual economic conference "Understanding Inflation and the Implications for Monetary Policy." During one of the panel discussions of then current policymakers I asked, "How about asset prices, shouldn’t they be included in the overall assessment of inflation? " To my dismay none of the policymakers agreed with me. Yet, a decade later, with two assets price busts in the rear view mirror and the present risk of third one it is clear that the Fed’s playbook is missing something. Policymakers need to rethink its playbook and include asset prices in their overall monetary framework.

The current playbook for monetary policy has been centered on a single variable as policymakers have established as their ultimate policy objective a specific rate of inflation in a single measure of consumer prices. At various points in history, monetary policy has relied on single indicators, such as the monetary aggregates M1 and M2 only to learn that economic and financial relationships change, requiring the policy framework to change as well.

Policymakers shifted to the new anchor, known as a price-targeting framework, to show their commitment towards price stability and to create a systematic way in which policy decisions would be made. Yet this approach has "glaring" holes and has outlived its usefulness.

Published consumer price indexes, which have been constantly changed over the years, are designed more along the lines of a cost-of-living index, which include market and non-market prices. As such, these consumer price measures don’t offer the "inflation clarity" or sensitivity to the economic cycles as they did in past cycles, especially since they exclude important price signals from the real estate market. And just like what happened with M1 and M2, price relationships to monetary policy also change and the prices that matter more today for economic growth and financial stability are those not targeted, such as asset prices.

The shift in price signals from consumer prices to asset prices reduces the efficacy of a monetary policy framework built on inflation targeting. Moreover, by continuing to try to achieve its price target by running with a low interest rate strategy increases the risk of inadvertently fueling more asset price inflation and at some point financial instability.

So how should policymakers change the playbook? At some point, policymakers may need to downgrade the currently published consumer price indexes as the primary policy guide as these price indexes no longer offer the "comprehensiveness" on economy-wide inflation. Before that happens policymakers and their staff could work with the statistical agencies to create a more robust price series. Change has been a constant feature of monetary policy and trying to improve the price statistics used in policy deliberations should be a priority.

Policymakers must also consider the use of official rates to maintain financial stability, as it has become an equal along side the Fed’s economic mandates of maximum employment and price stability. The current policy of using supervisory and regulatory powers to maintain financial stability has proven to be insufficient and official rates can fill in all "holes" that are being missed.

It is not lost on policymakers that the tipping point for each of the past two recessions has been abrupt changes in asset prices and the impact it had on balance sheets, consumer and business confidence and spending and investment decisions.

At the end of Q3 2018 household financial balances as measured against nominal incomes far exceeded the peaks of the tech-equity bubbles and housing bubbles. From a monetary policy perspective, the current run-up in financial balances might be the scariest of the three since policymakers have limited rate flexibility to counter an abrupt reversal in asset prices. To be sure, the level of official rates, even after this week’s 25 basis point increase, stands at 2.25% to 2.5%, well below the 6.5% and 5.25% levels that were in place in 2000 and 2007 respectively.

History sometimes repeats itself in the world of finance. Recurring asset bubbles have been proven to be a monetary event, and it is time to tell it like it is; the monetary experiment of price targeting has failed and a new Fed playbook is needed soon.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.