ANY central banker worth his salt knows that his job is to aim for price stability. But stability of which prices? Should central banks worry only about consumer-price inflation, or also about the prices of assets, such as equities and property? Mr Greenspan asked this question in December 1996 when he made his famous speech about “irrational exuberance” in the stockmarket. Since then Wall Street has climbed another 70%. How to deal with asset prices is now one of the most serious dilemmas of monetary policy.

Consumer-price inflation may currently be modest, but another sort of inflation, in share prices, is rampant. Many central bankers are privately worried about the lofty heights share prices have reached, but they do not believe there is much they can or should do about it. Such diffidence could prove damaging. Price stability, remember, is only a means to the end of maximum sustainable growth. And asset-price inflation can be even more harmful to growth than ordinary inflation.

Policymakers often claim that by pursuing price stability they will reduce the risk of boom and bust. But history suggests that, although price stability does deliver big benefits, it does not guarantee economic and financial stability. Indeed, there is reason to believe that financial bubbles may be more likely to develop during periods of low CPI inflation. The two biggest bubbles this century—America's in the 1920s and Japan's in the 1980s—both developed when inflation was modest.

One explanation is that when inflation is subdued, interest rates look low, thanks to “money illusion”:people fail to notice that in real terms rates are just as high as in more inflationary times. This encourages a borrowing binge and prompts investors to chase higher and hence riskier returns. When interest rates are low, people are also able to borrow a much bigger multiple of their incomes to finance speculative investment. At the same time, price stability can sometimes encourage economic euphoria. With seemingly no reason for central banks to raise interest rates, people start to expect that the expansion will continue indefinitely. This false sense of security encourages investors to take bigger risks, and lenders to relax their standards.

Flemming Larsen, the deputy director of research at the IMF, pointed out in a recent speech that there was much evidence that an economy can overheat even at a time of price stability as conventionally defined. Excess demand shows up instead in balance sheets and asset prices. Traditional indicators of inflation may mislead monetary policymakers. Central banks, he argued, should pay more attention to asset markets and to unsustainable balance-sheet trends, and may need to raise interest rates even if inflation remains low.

William McChesney Martin, governor of the Fed in 1951-70, memorably described the Fed's job as being “to take away the punch bowl just when the party is getting going”—ie, before the economy overheats and pushes up inflation. But there is more than one sort of party. The Fed has failed to remove the punch bowl from Wall Street's speculative binge.

By describing America's economy as a bubble in early 1998, The Economist made few friends for itself in that country. Optimists claim that the surge in share prices reflects the “new era” of rapid growth in productivity and profits, brought about by new technology and corporate restructuring. This, they argue, justifies the high share prices recently seen. The p/e ratio of the S&P 500 currently stands at 33, compared with an average of 14 over the past century. By every standard method of valuation, Wall Street is now more overvalued than it was on the eve of its crashes in 1929 and 1987.

United Stocks of America

It is true that there have been some genuine improvements in the performance of the American economy, justifying part of the rise in share prices. But only part. Irrational exuberance may have turned these genuine gains into a bubble, so that investors have unrealistic expectations of future profit growth and have convinced themselves that the old methods of share valuation are redundant. Indeed, there are remarkable similarities with America in the 1920s and Japan in the 1980s (see chart 6).

In the 1920s, people also believed in a new era of faster growth arising from new technology. The only difference was that at that time most of the excitement was generated by cars, aeroplanes, electrification and the radio, rather than by computers, telecoms and the Internet. Convinced, like many others, that the boom-bust cycle was a thing of the past, Irving Fisher, an economist at Yale University, made his infamous observation on the eve of the 1929 crash that “stock prices have reached a permanent and high plateau.” In the same way, in Japan in the late 1980s a belief at home and abroad that its economic model was superior to those of other countries convinced investors that strong growth and rising share and property prices could continue forever.

Today, besides runaway share prices, America shows plenty of other signs of excess. Consumers have been on a borrowing and spending binge, and household saving has turned negative for the first time since the 1930s. Firms are also borrowing heavily. As imports soar, America's current-account deficit is heading for a record 4% of GDP. The property market is also starting to look frothy: prices of prime residential property in many big cities are soaring. Last, but not least, money-supply growth seems excessive. These are all classic symptoms of a bubble.

Stephen King, an economist at HSBC, has drawn up a checklist of 12 tell-tale signs of bubbles based on previous episodes. In America ten out of those 12 are flashing red. Joseph Kennedy boasted that he got out of the market in 1929 because even shoe-shine boys were offering share tips. Perhaps today's equivalent is the New York taxi driver who keeps one hand on the wheel and the other on his laptop computer, punching in share orders online.

In many other countries, too, share prices have been rising rapidly. Indeed, over the past four years some European stockmarkets have risen by even more than Wall Street. But they started from lower levels, so they look less overvalued. More important, there are also fewer signs of excess, such as a borrowing binge. In general, households in continental Europe own far fewer shares than their American counterparts (see chart 7), so the increase in wealth from a booming stockmarket, and the effect on the wider economy, has been much smaller. That is why these economies are less vulnerable to a sharp fall in share prices.

The trouble with bubbles

If America is experiencing a bubble, what should the Fed do about it? There are four reasons why it (and other central banks) should worry about asset-price inflation:

•It can be a leading indicator of CPI inflation, if rising asset prices spill over into excess demand. The increase in wealth encourages consumers to splurge. At the same time rising share prices reduce the cost of capital, so firms invest more. American retail sales have jumped by more than 8% over the past year. So far, the effect of excess demand on prices has been offset by other factors. But for how long?

•The consumer-price index is a flawed measure of inflation. Ideally, an effective measure should include not only the prices of goods and services consumed today, but also of those to be consumed tomorrow, since they, too, affect the value of money. Assets are claims on future services, so asset prices are a proxy for the prices of future consumption. For instance, a rise in house prices today will increase the cost of future housing services. A classic paper written in 1973 by two American economists, Armen Alchian and Benjamin Klein*, argued that central banks should try to stabilise a broad price index that includes asset prices. Estimates suggest that in America such an index has recently been rising faster than at any time since the late-1980s boom.

•Just as high consumer-price inflation tends to blur relative price changes, surges in asset prices also distort price signals and cause a misallocation of resources. For instance, if the cost of capital is artificially low, firms may be tempted to overinvest in risky projects. American business investment has jumped from 13% to 18% of GDP over the past six years, similar to the surge in Japan in the late 1980s. As the quantity of investment surges during a bubble, its quality typically deteriorates.

•When a bubble bursts, it can cause severe economic and financial harm. Rising asset prices encourage excessive borrowing by firms and individuals, leaving them heavily exposed to a fall in asset prices and a recession. The longer the party continues, the worse the eventual hangover, because imbalances, such as the level of debt, will be even bigger.

Given these costs, there is a strong case for central banks to pay more attention to rising asset prices, and to raise interest rates to deflate a bubble in its early stages. This does not mean that central banks should try to target share prices, or change interest rates in response to every twitch in the Dow. But if a sharp rise in share prices is accompanied by rapid growth in domestic demand and a steep increase in borrowing, alarm bells should start ringing.

However, most central bankers, particularly those at the Fed, are hostile to the idea of trying to puncture bubbles. Monetary policy, they argue, should concentrate on stability in the prices of goods and services, and central banks should respond to asset prices only if they spill over into general inflation. Central bankers offer three reasons why they should not attempt to prick bubbles. First, they say, it is impossible to be sure that a rise in asset prices represents a speculative bubble, rather than an upturn justified by improved economic fundamentals. Intervening to prick a bubble, says Mr Greenspan, presumes that central banks know more than the market. But the market is not disinterested. It is to investors' and securities firms' advantage to keep a bubble going. Central banks, on the other hand, are able to take a more balanced view. True, it is impossible to estimate the “correct” value of equities, but monetary policy is always dealing with uncertainty. Central banks do not give up on trying to target consumer-price inflation just because they are unsure about the pace of productivity growth or the size of the output gap.

A second problem with pricking bubbles is that central banks have no laser-guided weapons for the purpose. The one they can deploy, interest rates, acts more like a nuclear bomb, affecting the whole economy. The link between interest rates and asset prices is also uncertain, so it is hard to know by how much to raise rates. Experience suggests that stockmarkets shrug off timid rate increases, but bold increases can have dangerous results.

Last, and most important, central banks do not have a political mandate to halt asset-price inflation. The awkward truth is that bubbles are popular. Whereas everybody accepts that inflation in goods and services is a bad thing, almost everybody regards rising equity and property prices as a good thing. If, by raising interest rates, the Fed were to reduce the wealth of the 50% of American households who own shares, it would not be long before Congress acted to curb the Fed's power.

Asset prices were high on the agenda at this year's annual meeting of central bankers at the Federal Reserve Bank of Kansas City symposium in Jackson Hole, Wyoming. Mr Greenspan devoted his speech to the subject, stressing the uncertainties in valuing shares. Much to his relief, no doubt, the paper on monetary policy and asset prices presented at the conference† supported the orthodox view that monetary policy should not respond to a rise in share prices unless it signals higher CPI inflation. But this conclusion was based on a model which simulated the economic effects of bubbles in a rather mechanical way. It did not take account of how investors' perception of policy might cause a bubble to inflate if, for example, they expect a central bank to cut interest rates when share prices fall, but to do nothing when they rise—as in America today.

How not to do it

There are two examples of central banks deliberately trying to burst a bubble: America in 1928-29 and Japan in 1989-90. Both attempts did indeed end in tears. But that was largely because both central banks left it very late before they acted, and then pursued over-tight policies after asset prices had crashed. The lesson may be not that central banks should keep clear of bubbles, but that they should intervene as early as possible to prevent them.

In Japan, share prices and property prices increased more than fourfold between 1981 and 1989. Geoffrey Miller, the director of the Center for the Study of Central Banks at New York University, who has studied Japan's bubble**, reckons that with hindsight it is clear that monetary policy was too lax. The Bank of Japan started to fret about rising property and share prices and rampant bank lending in 1987. If it had tightened policy then, the economic damage would have been considerably less. So why did the bank wait two more years?

Uncertainties about whether it really was a bubble and how asset prices would respond to higher interest rates both played a part. And as in America today, CPI inflation was low (in part because of a strong yen), so politically the bank would have found it hard to take action. But, says Mr Miller, the Bank of Japan also faced another constraint: political pressure from America. The Louvre Accord agreed by the G7 in early 1987 committed Japan to boosting domestic demand to help reduce America's trade deficit.

Mr Miller concludes that pricking bubbles is far from easy. But he argues that there will be times when asset-price bubbles become so large that they pose a threat to the entire economy—and when they do, central banks should raise interest rates to deflate them.

Two enemies, one bullet

A central bank has only one main weapon: interest rates. So if it decides to raise rates to prick a bubble when consumer-price inflation is already low, this could result in falling prices in product markets. But is that necessarily a bad thing? During previous periods of rapid productivity growth, such as the last quarter of the 19th century, average prices did fall. This was a benign sort of deflation, in contrast to the malign sort where output and prices spiral downwards. Perhaps, as argued in an essay in the latest annual report of the Federal Reserve Bank of Cleveland, prices should be falling now in America. The essay summarises arguments made by economists in the 1920s and 1930s, which suggest that at times of rapid technological change overall price stability and economic stability may be incompatible.

Indeed, it is possible that if rapid productivity gains are pulling down the costs of production, price stability might be the wrong goal. Earlier this century, several economists argued that increased productivity growth brought about by technological advances in the 1920s should have caused real incomes to rise as prices fell relative to wages. Instead, a lax monetary policy prevented prices from falling, and nominal wages lagged behind productivity growth. As a result, profits surged, and share prices soared on the false expectation that this happy state of affairs would continue indefinitely.

The essay asks whether this might describe the situation today in America. An overly lax monetary policy is counteracting falling prices, and so artificially inflating profits, which misleads investors. The surge in share prices causes an investment boom and the expectation of further gains attracts capital from abroad. The excess capacity thus created, and a strong dollar, have held inflation down, so the Fed has ignored excessive money growth. In this way, by aiming for a low but positive inflation rate, a responsible central bank could inadvertently pursue an over-expansionary monetary policy. Central banks, concludes the essay, need to be on guard against unusually strong money growth during periods of rapid technological change and exuberant financial markets. This does not mean central banks should throw away their long-run objective of price stability, but should set it in a broader monetary framework and recognise that price stability has limitations as an indicator of overall economic health.

Although most central banks have ignored asset prices, the Bank for International Settlements (BIS, the central bankers' bank) has been sounding the alarm for years. Its latest annual report expresses deep concerns about the surge in share prices in America. Charles Goodhart, a member of the Bank of England's Monetary Policy Committee, has also argued for several years that central banks have concentrated on too narrow an index of inflation. The focus on the CPI, he says, is one of the main reasons why monetary policy was too lax in Britain during the property bubble in the late 1980s, and then too tight in the early 1990s. In a recent paper†† he argues that housing and financial assets should be included in some way in a broad inflation index. But in practice this would be tricky, because asset prices are volatile and hard to interpret.

In its latest World Economic Outlook, the IMF accepts that there is no mechanical way to take account of asset prices in setting monetary policy, but vigorously agrees that central banks do need to pay much more attention to asset prices. “In particular, central banks should examine asset-price inflation in light of other developing imbalances that can be suddenly reversed, including external and private-sector financial balances as well as [rapid] growth in money and credit.” Is Mr Greenspan listening? The unexpected increase in British interest rates in early September, in response to rising house prices, suggests that the Bank of England is.

Central banks would be wise to pay attention to such advice, because international financial liberalisation may increase the future risk of bubbles. Bill White, chief economist of the BIS, argues that thanks to financial liberalisation, monetary policy now works increasingly through the exchange rate. When an economy expands rapidly and interest rates are expected to rise, the exchange rate quickly appreciates, helping to keep inflation in check. As a result, interest rates need to rise by less than they otherwise would, leading to a greater risk of bubbles in asset markets. In both Japan in the 1980s and America in the late 1990s, inflation has been held down by strong exchange rates.

Mr Greenspan recently conceded that: “If we could find a way to prevent or deflate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank.” Mr Greenspan first started to fret about America's current bubble three years ago. Ideally, an omniscient Fed should have tightened policy then; it is now too late to deflate the bubble gently. In December 1996, Mr Greenspan probably thought he was going to let out some air with his “irrational exuberance” speech, which was followed by a quarter-point rise in interest rates. Instead, share prices continued to surge. In light of the various technical and political constraints, he now seems to have decided that there is nothing he can do but cross his fingers and let the bubble burst by itself.

Anxious Alan

Nobody can predict when that will be, but eventually it will happen, perhaps because the dollar starts to tumble as foreigners become less willing to finance America's widening current-account deficit, or because rising inflation pushes up bond yields. Mr Greenspan thinks a slump in share prices need not be catastrophic for the economy if policymakers respond correctly. The Great Depression and Japan's recent slump, he argues, were caused not by bursting bubbles, but by excessively tight policies after asset prices had plunged. In contrast, says Mr Greenspan, after the 1987 stockmarket crash, central banks pumped liquidity into the financial system, and economies continued to expand.

Mr Greenspan's confidence that he can use monetary policy to prevent a deep recession if share prices crash exposes an awkward asymmetry in the way central banks respond to asset prices. They are reluctant to raise interest rates to prevent a bubble, but they are quick to cut rates if financial markets tremble. Last autumn, in the wake of Russia's default and a slide in share prices, the Fed swiftly cut rates, saying it wanted to prevent a credit crunch. As a result, share prices soared to new highs. The Fed has inadvertently created a sort of moral hazard. If investors believe that monetary policy will underpin share prices, they will take bigger risks.

Is Mr Greenspan right in thinking that a stockmarket crash would have as little impact on the economy as in 1987? The impact on consumer spending would be much bigger today, because about half of all American households now own shares either directly or via a mutual fund or pension plan, compared with just over a quarter in 1987. Moreover, the impact of the 1987 crash on consumption was modest because the stockmarket rebounded quickly. Today, a 40% drop in share prices (broadly the same as in 1987), if sustained for a period, would probably tip America into recession. Mr Greenspan may hope that he can prevent a deep recession by cutting interest rates, but America's economic imbalances, notably the level of private-sector borrowing, are getting so large that the landing looks quite likely to be hard.





* “On a Correct Measure of Inflation”, by Armen Alchian and Benjamin Klein. Journal of Money, Credit and Banking, volume 5, 1973.

†“Monetary Policy and Asset-Price Volatility”, by Ben Bernanke and Mark Gertler. Federal Reserve Bank of Kansas City Symposium, August 1999

**“The role of a Central Bank in a Bubble Economy”, by Geoffrey Miller. Cardozo Law Review, vol.18, No 3, December 1996

††“Time, Inflation and Asset Prices”, by Charles Goodheart, Eurostat Conference, August 1999