Asset price inflation and monetary policy.

From the perspective of this paper, what is of central interest is the effect on banks and other financial institutions of the asset price boom. In the six years since June 1994, total bank credit at all commercial banks has grown approximately 1.5 times. Components of that total that responded to the asset boom--real estate bank credit, bank credit backed by securities other than government securities, and security loans-increased at a somewhat more rapid rate than the total, 1 2/3 times, 2.3 times, and 2 times, respectively. Banks, however, are well capitalized, so their condition is not at this juncture fragile.

It is too early in the post-asset boom period to determine whether bank portfolios with such collateral will spell trouble for those lenders. Security collateral may be problematic to dispose of, presumably subject to a big loss. Banks will foreclose on property that is backing for troubled loans and then sell it. The real estate market has not as of the summer of 2002 suffered a retreat, so the banks may not be losers if the borrowers have trouble servicing their loans.

Some banks have already reported weaker earnings, and a surge in bad loans. It has been alleged that some of the nation's largest banks facilitated corporate concealment of losses and debts. Bank stocks since May 2002 have been battered by these allegations. Enron-related activities by big banks are being investigated by various agencies. How damaging to the financial system the outcome will be remains to be seen.

Money-center banks are in a different position. They have invested in venture capital underwriting, and advising on mergers and acquisitions. They syndicate big loans to corporations, usually not backed by collateral, arranging for a fee for several other banks and investors to accept a portion of the loan. Big syndicated loans to the big corporate miscreants that have filed for bankruptcy may well inflict losses on the lenders. Defaults on subinvestment grade lending, however, have not been a serious problem as of the first half of 2002.

The economy faltered in 2000 and initially the slowdown seemed not to signal recession. However, revised GDP data for 2001 show that the economy contracted during the first three quarters. The decline was shallow despite the shock of the 9/11 attacks. Before the release of the revised GDP estimates, the NBER dating committee designated March 2001 as the peak of the expansion dating from March 1991. GDP in the fourth quarter of 2001 rose 2.7 percent and 5 percent in the first quarter of 2002, falling to 1.3 percent in the second quarter. The economic recovery, weak as it appears to be, has continued despite the rout of equity prices

Conclusion

This brief survey points to two negative admonitions for central banks. The first one is, Do not engage in monetary expansion out of concern for depressed asset prices. The second admonition is, Do not direct monetary policy to deflate asset price booms. Let the market correct itself when asset price booms appear to be bubbles. The Federal Reserve is not the arbiter of the correct level of asset prices.

Equity market prices don't escalate in the absence of favorable earnings growth projections; they don't collapse unless those earnings growth projections are diminished. There may be lots of noise surrounding these basics, but the noise should not obscure the underlying reality.

Recently Henry Kaufman [2002] has argued that plummeting stock prices are cause for concern because of their direct bearing on the real economy. He urges the Fed to support equity prices by reducing margin requirements on stocks, which he characterizes as an underutilized tool.

The direct effect of the stock market usually referred to is the wealth effect that was supposed to stimulate or retard consumer spending. The failure of consumer spending to respond to the stock market collapse in the years since 2000 has muted the belief in the potency of the wealth effect. Kaufman, however, has in mind a different direct effect, namely, the general malaise associated with the shutdown of the IPO market, high borrowing costs for established businesses, restricted access to low-cost commercial paper issuance, the shrinking high-yield corporate bond market -- threats to recovery, all of which he associates with the depressed stock market. Reducing margin requirements hardly seems an effective cure for these problems.

Kaufman's second recommendation, however, is more to the point, but is unrelated to monetary policy. He believes that President Bush should propose and Congress enact a reduction in the capital gains tax and the elimination of the tax on corporate dividends. Only if these measures don't stabilize the stock market would Kaufman advocate a reduction of the Fed funds rate and across the board cut in taxes. I would agree that tax policy is the appropriate tool to improve the climate for investment.

Achieving a low commodity price inflation rate remains the paramount central bank responsibility. Should commodity price inflation emerge, before central banks attempt to divine whether it is attributable to asset price inflation, they would be well advised to make sure that lax use of their interest rate instrument is not at fault.

What is crucial, however, is that central banks and regulatory authorities, be aware of effects of asset price fluctuations on the stability of the financial system. Lending activity based on asset collateral during the boom is hazardous to the health of lenders when the boom collapses. One way that authorities can curb the distortion of lenders' portfolios during asset price booms is to use capital requirements that increase with credit extensions collateralized by assets whose prices have escalated. If financial institutions avoid this pitfall, their soundness will not be impaired when assets backing loans fall in value. If there are troubled financial institutions, following an asset price collapse, restoring them to sound condition ranks first among the authorities' urgent priorities. No economy can prosper without a well-functioning financial industry.

Footnotes

(1.) Weekly reporting members of the Federal Reserve System in leading cities from December 1919 on provided Wednesday figures on their loans and investments [Banking and Monetary Statistics 1943, pp. 133-42]. Before 1929, total loans distinguished loans on securities from all other loans. Beginning 1929 the category of loans on securities was further classified into loans extended to brokers and dealers (those in New York City shown separately from those outside New York City) and loans to others than brokers and dealers. The authorities also had quarterly reports on brokers' loans by New York City banks, by other banks, and by others [ibid., p. 494]. Another data set shows loans to brokers and dealers made by daily reporting banks in New York City, for their own account and for correspondents, weekly, from October 1917 through January 1926 [ibid., pp. .496-97]. Thereafter weekly data for loans to brokers and dealers, secured by stocks and bonds, are available for weekly reporting member banks in New York C ity [ibid., pp. 498-99].

Brokers used their loans to provide the call loan market. Investors who bought equities on margin borrowed the difference from a broker who had a daily option to call the loan, which paid a floating interest rate. Dealers borrowed pending the distribution of shares to investors.

Loans to brokers and dealers by member banks were a particular bane of the Board. As member banks reduced such loans on their own account, they made loans for the account of correspondent out-of-town banks and in 1929 increasingly for the account of nonbanking lenders-- private investors and corporations--and foreign banks [ibid., p. 498].

(The banks did not report loans on real estate or types of loans other than loans on securities until September 1934)

(2.) I owe comments by George Kaufman on an earlier version of this paper for the present reliance on capital requirements as the solution to the problem of portfolio distortions during asset price inflations.

(3.) Wigmore 1985, App. 19, pp. 637-39.

References

Annual Report, 1929, Federal Reserve Board. Washington, D.C.

Banking and Monetary Statistics 1914-1941, 1943. Board of Governors of the Federal Reserve System.

Bernanke, Ben; Gentler, Mark. "Should Central Banks Respond to Movements in Asset Prices?" American Economic Review, Vol 91, May, 2001, pp. 253-7.

Cecchetti, Stephen G.; Genberg, Hans; Lipsky, John; Wadhwani, Sushil. "Asset Prices in a Flexible Targeting Framework." Chicago: Federal Reserve Bank of Chicago and the World Bank, 2002.

-----. Asset Prices and Central Bank Policy. London: International Center for Monetary and Banking Studies, 2000.

Economic Statistics Annual 1997. Research and Statistics Department, Bank of Japan.

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Goodhart, Charles. "What Weight Should be Given to Asset Prices in the Measurement of Inflation?" Economic Journal, Vol 111, June, 2001, pp. F335-F356.

Kahkonen, Juha. "Movements in Asset Prices Since the Mid-1980s" in Ulrich Baumgartner and Guy Meredith eds. Savings Behavior and the Asset Price "Bubble" in Japan, Washington, D.C.: IMF, 1995.

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