In medieval Europe financial institutions issued their
own banknotes, each denominated in the respective currency of the bank. With
the establishment of central banks starting in the 17th century
with the Bank of Amsterdam, not only
the usage of deposit money became popular,
but also the supply of money was centralized.
Nowadays the Fed, the ECB, and other central banks
issue currencies, which possess the status of a legal tender. These banks
are thus the only suppliers of the liabilities (the monetary base), which
commercial banks in turn need as legally required minimum reserves, as balances
for settling interbank claims, and, through the
fractional reserve system and the resulting monetary
multiplier, the central bank can thus control the entire money supply.
This ability puts the monetary authorities into a very important position for
achieving specific macroeconomic goals.
For most central banks the main objective is to
maintain price stability. The reason for this lies in the well documented
positive relationship between money growth and the price level in
the long term. According to Goodhart (1994) other
important goals of monetary authorities are
sustaining high employment and economic activity,
reducing interest and exchange rate variability, and maintaining
systemic stability of financial markets. However, target conflicts can emerge
when central banks try to reach several goals simultaneously. In the last
decades macroeconomic literature discussed very extensively the relationship
between unemployment and inflation. Thereby the contributions of Phillips
(1958), who was one of the first to discover a reverse interdependence, and
Lucas (1976), who criticized the exclusion of expectation in the adapted
econometric models, had huge influence in their field. Recently, due to the
growing complexity of financial markets, the role of monetary policy to ensure
the stability of financial markets and the interaction with other objectives
became a prominent field of research and discussions.
In the view of Bernanke
and Gertler (2001, p.14) “central banks
can and should treat price stability and financial stability
as consistent and mutually reinforcing objectives.” That seems to be true for
the long term, since only sound financial markets can provide a steady state
process of moderate volatility and economic activity, while systemic distress
and even a following banking crisis and credit crunch can lead to a deflationary
spiral. At the end, this can even be more harmful
to the goal of price stability than
temporary inflation, because central banks then face a situation
called liquidity trap, in which interest rates touch the zero lower bound
and ordinary monetary policy measures lose
its potency to steer the economy (see Keynes,
1937).
In the short run however, the relationship between the
goal of price stability and financial stability, which includes sustainable
developments of asset prices, is not so clear, especially in times of booming
markets. (see Issing, 2008). This issue was also addressed by Alan Greenspan
during a debate that took place inside the FOMC on September 24, 1996:
"What is really needed to keep
stock market bubbles from occurring is a lot of
product price inflation. There is a clear trade-off, if monetary policy succeeds in one,
it fails in the other. Now, unless we have the capability of playing in between and
managing to know exactly when to push a little here and to pull a little there, it is not
obvious to me that there is a simple set of monetary policy solutions that
deflate the bubble."
product price inflation. There is a clear trade-off, if monetary policy succeeds in one,
it fails in the other. Now, unless we have the capability of playing in between and
managing to know exactly when to push a little here and to pull a little there, it is not
obvious to me that there is a simple set of monetary policy solutions that
deflate the bubble."
After this speech, between early 1998 through
February 2000, the Internet sector earned over 1,000 percent returns on its
public equity. That the Fed did not react and did not increase
interest rates earlier was criticized among others by Roubini (2006). He
accused the Federal Reserve of not having neither “pricked” the stock market
bubble in 1997, nor when the “evidence was obvious” in 1998-99. He also
criticized the passivity of the central bank in the uprising housing price
bubble. Also White (2009) supported an intervention of monetary policy in price
misalignments in addition to a tighter collaboration with regulators to encounter
the procyclicality of financial markets. The author stressed that the so
called “Greenspan Put” led to moral hazard and encourage higher risk taking,
since policy makers were inactive during the boost of asset prices (see also
Florio, 2006).
Other supporters of “leaning against the wind of asset
prices” among others were Cecchetti et al. (2000). By using the new-Keynesian
framework, they found that during a rising bubble, optimal monetary policy
should be tighter than a simple Taylor rule would suggest, while the opposite
would be true for the time when the bubble bursts.
However, using a similar type of model, Bernanke
and Gertler (2000, 2001) suggested that asset prices should not be targeted
directly. In their opinion, a concentration on expected inflation leads to
optimal outcomes. In both papers the authors adapted a New-Keynesian model and
incorporated informational frictions in credit markets. In Bernanke and Gertler
(2001) the authors criticized Cecchetti et al. (2000) that their procedure
would yield a truly optimal policy only if (i) the boom is driven by
non-fundamentals and the central bank knows about it and (ii) it also knows
exactly when the bubble bursts. Thus Bernanke and Gertler recommended rather a
“cleaning after the bust” than a “leaning against the wind”
Another contradiction of the latter theory is Posen
(2006). One of the authors’ central arguments is that the “lack of
effectiveness of monetary tightening to pop bubbles or to respond to financial
fragility, and the far greater cost of inducing recessions than riding bubbles
out, are structural factors characteristic of modern financial systems and of
bubbles.” That is why “the cost–benefit analysis inherently goes against
popping bubbles and in favor of monetary easing after busts.” (Posen 2006, p.121).
This argument shows that it is crucial to know not only the impact of monetary
policy on the economic activity and aggregated demand in general, but also on
specific asset classes. Since every asset class reacts differently, it is
important to know about these effects when the monetary transmission mechanism
is to be investigated and optimal monetary policy is to be conducted.
Apparently, whether monetary policy should “lean
against the wind of asset prices” or “clean after the bust” depends
particularly on the size of the effect that it has on asset prices. If no
impact existed, then the pricking of the bubble would not be possible anyway.
Otherwise, if interest rate policy had a huge influence, then a “leaning
against the wind” would be more effective and relatively cheap. This work
contributes to the discussion insofar that it provides, as one of the first
studies, the quantitative methodology and estimations for the European market,
which in turn are needed to conduct a reliable and reasonable response of
monetary policy.
The reader should be aware that several other
extraordinary policy measures exist, which are not covered by this analysis.
These can consist of the following: Granting direct long term loans (credit
easing), buying government or covered bonds (quantitative easing), decisions
about the eligibility of securities for secured borrowing from the ECB, changes
in the minimum reserve requirements for banks, the status of lender of last
resort, and management of expectations in general. All these measures affect
asset prices, depending on its type and its magnitude. Since a lot of
these policy tools have been applied in the aftermath of the Lehman collapse in
2008/09, I exclude this period from the examination, to be sure that only the
effect of interest rate changes is measured, as shown in section 5 of my diploma thesis.
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