TCA Srinivasa-Raghavan: No whole answers at Jackson Hole

OKONOMOS

Does the use of monetary policy to manage house purchase decisions resemble "adding a grain of sand a day to a scale weighing a car?".

Like a peahen startled by an unexpected peacock, the Sensex has leapt upwards beyond 16,000. The peacock in question here is the US Federal Reserve Bank (The Fed), which is the American counterpart of our own RBI. Quite unexpectedly it has cut the overnight interest rate by 50 instead of the expected 25 basis points. In the process it has also proved the last RBI governor right: if a central bank must spring surprises, he thinks, let it be a pleasant surprise.

What the Fed (and other central banks) should do when faced with asset price bubbles was the subject of discussion at the annual Jackson Hole Conference this year.

The theme this year was housing, housing finance and monetary policy. Five papers were presented and you can find them at http://www.kansascityfed.org/home/subwebnav.cfm?level=3&theID=9954&SubWeb=5. If nothing else it will demonstrate to you how those who have to manage the economy think very differently from the way those who merely offer academic advice on it.

The key issue, as can be imagined, was not just the extent of the rate cut but also whether central banks should intervene to stabilise the financial markets. Some say they shouldn't because that kind of intervention only encourages the bad boys "" greedy banks, stupid kids in hedge funds "" to behave even worse. The opposite, political view is that if there is no intervention, innocent bystanders can "" and will "" get hurt when a recession ensues as a result of such studied non-action.

Robert Shiller, a professor at Yale, presented a paper called "Understanding Recent Trends in House Prices and Home Ownership" (http://www.kansascityfed.org/publicat/sympos/2007/
PDF/2007.09.14.Shiller.pdf ) in which he argued that while no can predict the future and house US prices may well rise, it seems reasonably certain that they will decline by at least 15 per cent in the foreseeable future. But he also said that to the extent a great deal also depends on peoples' expectations about the future, "using monetary policy to manage such decisions is like adding a grain of sand a day to a scale that is weighing a car."

Frederic S Mishkin, who is a member of Board of Governors of the Federal Reserve System, presented a paper on " Housing and the Monetary Transmission Mechanism (http://www.federalreserve.gov/pubs/feds/2007/200740/200740pap.pdf). He said that although he did not think central banks should keep their gaze focused on house prices while deciding monetary policy, it also made no sense for them to "stand by idly when house prices climb steeply." In short, he seemed to suggest that central banks should act to prick asset price bubbles. But how do you tell when it is a bubble and not just a normal supply-demand thing?

He also said that "a prudent central bank would be better advised to deal with adverse macroeconomic consequences as they emerge" when asset prices start to collapse. The point of a central bank intervention, he seemed to suggest, was "to achieve maximum sustainable employment and price stability." In other words, politics.

John Muelballer of Oxford University in a paper called "Housing credit and Consumer Expenditure" (http://www.kansascityfed.org/publicat/sympos/2007/
PDF/2007.09.17.Muellbauer.pdf ) argued that cheap money has introduced house prices into the wealth effect, so that when house prices decline people feel poorer (which it seems was not the case earlier) and reduce their overall consumption expenditure.

Martin Feldstein, who is well known in India and who has recently quit as the head of the National Bureau of Economic Research, called for a 100 basis point cut in the overnight rate (http://www.kansascityfed.org/publicat/sympos/2007/PDF/
2007.09.05.Feldstein.pdf ). The logic was that it is better to be safe than sorry.

The balance was thus in favour of intervention, for two reasons I think. One is that no central bank chief wants to be held responsible later for not warding off a recession. So he or she does the popular thing. The other reason is perhaps that everyone has learnt from the Asian crisis that when the going gets tough, the credit flow must start going. To choke off the tap is to invite disaster where people who had nothing to do with the problem lose their jobs and property.