NCPA - National Center for Policy Analysis

Central Banks Urged To Pay More Attention To Stocks

May 12, 2000

Some international economists want the U.S. Federal Reserve to attach greater emphasis to stock market levels when considering interest-rate increases. That advice directly contradicts the prevailing wisdom among central bankers.

In a report, "Asset Prices and Central Bank Policy," four economists say the U.S. Federal Reserve and its counterparts should raise interest rates when stock markets or real-estate prices are grotesquely out of line with fundamentals or rise well above historical norms. Their study will be published next month by the Graduate Institute's International Center for Monetary and Banking Studies.

  • Had the Fed been following their advice, they say, U.S. short-term interest rates would have been around 7.25 percent late last year -- about 2 percentage points higher than they were.
  • Current central-bank dogma -- shaped by mistakes the Fed made in the late 1920s -- holds that policy makers should focus primarily on stabilizing prices of goods and services and take stock or real-estate prices into account only to the extent they influence consumer and business spending.
  • Many central bankers and academics say using interest rates to prick stock-market bubbles risks confusing markets, undermines public support for central banks and could endanger economic stability.

Central bankers say it is impossible to distinguish between a rising stock market and a bubble. But the new study argues that central banks already rely on measures which are just as difficult to estimate -- such as the quantity of goods and services an economy can produce without generating inflation.

Source: David Wessel, "Economists Question Theory on Interest-Rate Increases," Wall Street Journal, May 12, 2000.


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