08 June 2006

The need for broad, meaningful targets

Broad targets, rather than proliferating Mickey Mouse micro-targets, are essential if government is going to maximise societal well being. The British Government has opted for narrow, micro-targets in its attempts to run education and the National Health Service, but another perhaps even more crucial area is that of monetary policy. Mr Han de Jong of the ABN Ambro Bank in a letter to the editor of the Financial Times (published today) reckons that controlling banks don't know how to deal with asset price inflation. They have targets for 'normal' inflation - typically the costs of consumer or producer goods and services - but these generally exclude (except indirectly) asset price inflation.

... Central banks are reluctant to include asset prices in monetary policy decision-making. They argue that they cannot determine the right level of asset prices any better than the market. Funny that, as central banks have no such reservations about their abilities when it comes to the price of money. In addition, they are not sure how to fight asset price inflation. To me it seems relatively simple. A combination of strong growth, modest consumer price index inflation, easy money, strong credit growth and strong asset price increases suggests that monetary conditions are too loose. The economy in the eurozone is recovering and growing at a rate close to its potential. In spite of two European Central Bank rate increases, real official interest rates are barely positive. This is asking for trouble. As far as the eye can see, euribor futures contracts are pricing in money rates below 4 per cent. Assuming a 2 per cent inflation rate, that means rates will peak in this cycle well below their long-run average in real terms. If this happens, asset markets will continue to bubble. From time to time, those bubbles will inevitably pop.
For myself, I think monetary targets should be subordinated to outcomes that more directly measure social and environmental well being. Things that would take in, for example, homelessness and poverty. Under a Social Policy Bond regime targeting poverty an independent central bank would be motivated to reduce asset price inflation ... if doing so were an efficient way of dealing with poverty. Unfortunately what we have now are monetary targets that aim to restrain 'normal' inflation, but leave asset price inflation untargeted. For hard-working families in the UK and New Zealand (the two countries I know most about) this makes owning their own home a dream for ever.

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