Bubbles and monetary policy

The key issue for the Fed is how to handle the housing bubbles and the fall-out from the credit crisis during a rising inflationary period. The choice was relatively easy when the US did not have growing inflation pressure. Bail-out housing in an effort to sustain growth. The inflationary pressures existed last year but the commodity shocks and the acceleration of inflation has made the trade-off a more pressing issue.

The current policy trade-off is further exacerbated by the context of any policy decision and the measurement framework for inflation. The Fed is a central bank with joint objectives. The Fed is responsible for both price stability and growth. If the sole objective was price stability, the issue of what to do or what would be allowed would be easier to address. Right now there is significant confusion on whether the Fed should focus on the real economy or on price stability. The market and the Fed itself seemingly vacillate between which of these objectives should have priority.

But even in the case of a single objective, the inflation problem is exacerbated because of how the US inflation indices are calculated and what the Fed means by inflation. Simply put, the composition of the price index matters. In the current situation, the issue is whether asset prices should be included in an inflation index. Because asset prices and the associated bubbles are outside the price system it is unclear what is the responsibility of the central bank. Whether the Fed should stop inflationary asset prices is not directly addressed in growth or inflation objectives. The aftermath of a bubble may cause the Fed to act but the run-up to the decline is not addressed. The policy of ignoring a bubble because they cannot be “identified” but acting to protect the economy from the fall-out is tantamount to creating a moral hazard problem. The Greenspan put is institutionalized.

Additionally, the concept of core versus headline inflation creates further noise in monetary policy. Specific shocks, that will have spillover effects for the general economy, will not be addressed until after they have been internalized in the general price level. Again there is uncertainty on how these shocks will be addressed. Finally, the adjustments which try and adjust for quality in the basket used for measuring inflation distorts what may be the actually income used to purchase a set of goods.

The lack of clear objectives and the uncertainty on what constitutes inflation means there is significant noise surrounding what the Fed will be or should be doing. No wonder there is so much focusing on the speech of the chairman and Fed presidents. The noise causes more volatility which further affects the financial system and causes a delay or reduction in the decisions by banks and other financial institutions.

As inflation rises and the level of inflation and policy noise increase, there will be further questions on the efficacy of the current targeting approach. One hopes that the Fed will provide clear signals for the market before too long.