COLUMBUS, Ohio -- The U.S. Federal Reserve and other countries' central banks should raise interest rates when stock markets or other asset prices, such as housing prices or exchange rates, rise well above what is warranted by economic fundamentals, according to a report by prominent economists.
The conclusion is controversial among many economists, who believe central banks should ignore asset prices such as stocks and real estate when setting interest rates, said Stephen Cecchetti, co-author of the report and professor of economics at Ohio State University.
But Cecchetti said it is vital for policy makers to consider asset prices in order to stabilize inflation and prevent cycles of economic booms and busts.
"It's important to realize that asset price movements can have strong effects on future growth and inflation," said Cecchetti, who is former research director of the Federal Reserve Bank of New York.
"Central banks can improve their effectiveness - and lessen the likelihood of economic instability - by taking asset price shifts into account when setting interest rates."
If the stock market rises in a way that is unjustified by economic fundamentals, it becomes too easy to borrow money and firms can make investments that are not going to be profitable when the stock market has normal rates of return, Cecchetti said. When the economy begins to slow, many firms will be left with bad investments, and it will be difficult for them to repay the money they have borrowed. Solvency problems can ripple through the economy, and result in overall instability.
Cecchetti said he and his co-authors are not suggesting the Fed, or any central bank, should try to burst stock market bubbles - situations in which the stock market is obviously overvalued.
"What we should be trying to do is keep bubbles from developing in the first place," he said. "The way to do this is to raise interest rates slowly as asset prices begin to move above fundamentals. In the case of the U.S. economy, following our proposed strategy would have meant very slightly higher interest rates beginning about five years ago."
Many economists argue asset prices should not be considered in setting interest rates because it is extremely difficult to measure if asset prices are indeed misaligned with the economy. "But that's not a reason to ignore them," according to Cecchetti. "It is equally difficult to estimate the sustainable growth rate of the economy, something all central banks must do now to set interest rates."
Cecchetti wrote the report with Hans Genberg of the Graduate Institute of International Studies in Geneva; John Lipsky, Chase Manhattan Bank's chief economist; and Sushil Wadhwani, a current member of Bank of England's Monetary Policy Committee.
The report, entitled "Asset Prices and Central Bank Policy," was published by the International Center for Monetary and Banking Studies, part of the Graduate Institute of International Studies, and is available from the Centre for Economic Policy Research in London at www.cepr.org.
Written by Jeff Grabmeier, (614) 292-8457; Grabmeier.1@osu.edu