Deus Forex Machina


You are one of the few central bankers who believe asset prices are an important signal for monetary policy… How should we be thinking through the management of asset prices, particularly in light of the current environment?

I’ve been interested in international economics for 30 or 40 years. One of the things that really stands out from the first two-thirds of my career is that the economy responded mainly to real economic shocks; it responded to an oil price increase, inflation going up or the need to reduce inflation, and, in a country like Australia, whether commodity prices were rising or falling. In the latter third of my career I came to think that the financial sector is increasingly the source of the major shocks and not the real side of the economy. The nature of financial sector shock is that a period of excessive optimism occurs, a boom, when asset prices rise to a very high level. This is followed by a period of bust where everyone runs for cover.

The Asian crisis was essentially a financial shock. Excessive short-term lending to Asian countries, which set up booming asset markets there, followed by a trigger, which was in Thailand, and suddenly the money all rushing out again. Long Term Capital Management was definitely a financial market shock. The 2001 recession in most G7 countries was again a financial market shock precipitated by the dotcom boom and bust and the associated collapse in business fixed investment, which led to a recession. A mild one, but nevertheless a recession. That happened not that long ago, that was 2001.

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Six years later we’re having a re-run and this time, instead of it being an equity market event, it’s a credit market event.

I think basically the biggest single cause for this particular asset-price boom and bust is the massive excess supply of savings over investment in Asia working its way through the system and wherever the markets were craziest was where it was eventually going to show up. It turns out the craziest markets, as is normally the case, are in the US. We have seen this unbelievable collapse in lending standards in the mortgage market and also a generalised under-pricing of risk in all markets. So we’re now really having our fourth major financial shock to the world economy in the last 10 years.

And what do central banks do about it? What does policy in general do about it? The fact is, central banks do not have a mandate to do anything about an asset-price boom and bust. This is particularly troubling given that asset-price boom and busts are at least as likely to occur in a low-inflation environment as in a high-inflation environment. In fact, some of my former colleagues would say more likely to occur in a low-inflation environment.

It took 30 years for the relationship between central banks and governments to get sorted out into this implicit social contract where the central bank is given independence to pursue either an explicit or implicit inflation target. This has worked extremely well in the sense of what the central banks were asked to do, they have achieved. Their Consumer Price Index (CPI) target has been achieved. I don’t know how long it would take before we ever resolve the issue of who will become responsible for asset prices and equilibrium in the asset markets. But, at the moment, the central banks don’t have the responsibility. In fact they’re actually almost in a worse position. You can see this happening now that the bust is occurring and everyone turns to the central bank and says “fix” the bust.

But they’re not allowed to fix the boom. This, of course, is engendering a moral hazard problem and it helps explain why we’ve had four financial crises really in 10 years.

The inflation question is very important at the moment. Part of the reason we’ve seen this leveraging up of portfolios in recent years is because there was no fear of higher inflation and, therefore, no fear of higher interest rates…[and] core CPI is either flat or slightly falling in most major countries. But the things that a person actually needs to buy to live their life are all skyrocketing upward, from education to health care – even the price of cheese on a pizza is up 78 per cent in 12 months in the US… The official number isn’t reflecting real people’s experience.

I think that’s a bit unfair.

The one statistic I have real faith in is the inflation numbers – particularly the CPIs. I think the explanation for what you’re saying is that the statisticians of the world aren’t correctly measuring inflation. They’ve each got huge samples, 6000 items, and they make sure that you know each quarter it’s exactly the same thing they’re measuring and they’re taking account of the discounting and all that, or lack of discounting. They put an enormous amount of effort into it. The issue is that big-ticket items, particularly internationally manufactured trading goods prices, are falling and other things are going up. Again you’ve got to go back to Asia for the explanation. It is the massive increase in Asian capacity that is simultaneously holding down goods and services inflation and driving up asset inflation.

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