The Bank of Canada has released the Bank of Canada Review: Summer 2010 with articles:
- Lessons Learned from Research on Infl ation Targeting
- Monetary Policy and the Zero Bound on Nominal Interest Rates
- Price-Level Targeting and Relative-Price Shocks
- Should Monetary Policy Be Used to Counteract Financial Imbalances?
- Conference Summary: New Frontiers in Monetary Policy Design
The Financial Imbalances article points out:
Another potentially important cost of leaning against
fi nancial imbalances stems from the difficulty of identifying them and of calibrating an appropriate response. If fi nancial imbalances are falsely identified, responding to them through monetary policy could induce undesirable economic fluctuations (Greenspan 2002; Bernanke and Gertler 1999).
The question, according to the authors, is:
Granted that appropriate supervision and regulation
are the fi rst line of defence against financial imbalances, the key question is whether they should be the only one. In this context, developing a view on whether monetary policy should lean against financial imbalances requires that we first examine the interaction between the effects of prudential tools and those of monetary policy on fi nancial imbalances that stem from various sources.
A credit-fuelled housing bubble is a particularly relevant example of a fi nancial imbalance. This section considers the case of over-exuberance in the housing sector, represented as a temporary increase in the perceived value of housing that results in a short-term surge in mortgage credit. This example is calibrated to produce housing-market dynamics that are roughly similar to those of the housing market in the United States in the run-up to the recent crisis. Specifically, the size of the shock is set at 5 per cent of the value of housing collateral; this leads to an average increase in mortgage debt in the first year of about 16 per cent, comparable with the average annual growth rate of mortgage debt over the 2003–06 period.
We evaluate the relative merits of using monetary policy to contain this imbalance and compare it with a well-targeted prudential instrument—namely, an adjustment in the mortgage loan-to-value (LTV) ratio.
The authors have the fortitude to emphasize:
As mentioned in the introduction, one important argument against using monetary policy as a tool in these situations is that fi nancial imbalances cannot be detected with certainty. This uncertainty applies not only to monetary policy, but also to prudential policy, and should play a role in determining how forcefully to react to the prospect of building financial imbalances.
By me, this is such an important consideration that it virtually negates the concept of leaning against the flow. I am in favour of a progressive surcharge on banks’ Risk Weighted Assets based on how much these have changed over the past few years, but that’s based more on management factors than economic ones.
By definition, a bubble will have lots of defenders ready to explain why it is not a bubble, as discussed recently in FRBB: Bubbles Happen. Trying to nip bubbles in bud on the basis of a bureaucrat deciding that eggs should cost $2.99 a dozen and $3.25 is too much is fraught with dangers.