The power of asset prices: monetary policy must change to reflect the dominant role of asset values in economic performance.

Over the last two decades, tradable assets--and changes in their value--have moved to center stage in the performance of the major economies. In a diverse range of countries including the UK, Japan, South and East Asia, and recently the United States, booms and busts in property and/or stock prices have played a crucial role in the business cycle. This has important implications for the economic outlook as well as for monetary policy, bank regulation policy, and fiscal policy.

It is likely that the key to the performance of the U.S. economy (and the UK economy) over the next year will be what happens to stock and housing prices. If they fall again, then the recession in the United States will be deep and significant, while the UK, now widely expected to avoid recession in the current world downturn, will not escape either. But if confidence in asset prices is maintained, through a combination of low interest rates and reassuring economic and geopolitical developments, the anticipated V-shaped recovery should proceed according to plan.

A key reason for expecting the V-shaped recovery in the United States is that, entering the slowdown at the beginning of this year, the U.S. Federal Reserve Board had up to 6.5 percentage points worth of interest rate cuts available to support asset prices. In the previous peaks the Fed had even more ammunition. In 1981, the Federal Funds rate peaked at 19.1 percent and was cut by 10.5 percentage points in the subsequent three years. In 1989, it peaked at 9.8 percent and was reduced by 7 percentage points by 1993. In the current cycle, the Federal Funds rate was cut 4.5 percentage points through the end of 2001, and the Fed has signaled it will not hesitate to cut more if necessary in 2002, since inflation is not an immediate problem.

In the next cycle, there is a real possibility that rates will peak at a lower level, since inflation is likely to be reduced to near zero over the next couple of years, given the very strong deflationary forces in the world economy. So, while interest policy most probably will be effective this time, the next downturn could be more difficult to fight with interest rate cuts alone. Fiscal policy may be able to play an important role and the lesson of the current cycle is that countries which have successfully reduced their government debt ratios during the upswing, such as the United States and UK, are in far better shape than those which have not. However it will be crucial in the world of very low or zero inflation to avoid excessive swings in asset values that tend to bring "aggravated" downturns.

The pivotal role of asset prices would not surprise economists who have studied the pre-World War II period. The 1945-85 period was unusual because asset prices played a lesser role, while developments in credit availability, balance of payments flows or oil prices frequently played the dominant role. Moreover in the 1970's, the role of asset prices was eclipsed by the general inflation of the time, which often hid major declines in real asset prices and limited banking crises. For example, UK residential property prices fell 33 percent in real terms between 1973 and 1977, according to the Nationwide Index, but because of rampant inflation, nominal prices actually rose 31 percent. With the help of low or negative real interest rates in the same period the UK secondary banking crisis was relatively quickly resolved.

There are six broad reasons why asset prices have become so important. First, there is a long-term trend to increasing real wealth as incomes rise and people live longer. Second, there has been a sharp increase in the share of wealth in the form of tradable assets, priced in the markets, which has occurred due to the increased sophistication of financial markets and investors and the declining role of bank deposits. The development of asset markets has also been facilitated by the computer revolution for example in the development of securitized mortgages and online trading.

Third, there has been an increasing value placed on assets, certainly in the United States and Europe, reflecting high (and perhaps sometimes unrealistic) expectations, the end of the Cold War, the technology revolution and the easy availability of credit.

Fourth, falling interest rates due to disinflation seem to have played a large role. In the 1970's much was written about "money illusion," the difficulty people had in realizing that the real value of money as a unit of value was decreasing rapidly in the face of inflation. We may now be seeing a period of "value illusion," as people do not realize that the apparently inevitable upward march of asset prices is much less certain in a world of zero inflation. In the UK, for example, falling interest rates are routinely proposed as a reason for expecting house prices to continue rising. But if interest rates are falling because of lower inflation, the outlook must also be for lower long-term house price inflation. In general, investors need to look for lower returns.

Fifth, in many countries the growth of tradable asset markets has been encouraged by government policies, such as promoting the development of capital markets, encouraging small investors to participate, reducing government pensions, encouraging home ownership and tax policies favouring capital gains over interest income. There may also be an expectation that central banks will respond vigorously to falling asset prices, the so-called "Greenspan put," which encourages increased risk-taking.

Finally there is an increasingly close linkage between the value of assets and current spending on consumption and investment. Higher wealth not only encourages people to spend more because they feel richer but, with the help of financial innovations such as easier re-mortgaging, also enables increased borrowing. Consumer balance sheets have therefore expanded rapidly over the last twenty years. In contrast the story of Japan in the last decade has been that the steady grind down in stock and property prices has undermined confidence in future wealth and pensions and held down spending.

An important innovation in the United States has been the stronger link built between stock prices and compensation through the pervasive use of options. This is welcome in terms of the increased flexibility for companies but also makes consumer spending more dependent on asset prices. We may also find out in coming months that government revenues are more linked to asset prices than commonly thought through gains on stock option exercises and other capital gains.

Corporate investment is linked to asset prices in several direct and indirect ways. The boom in technology stocks encouraged a huge wave of investment, and now a sharp drop. More generally there are increasing problems emerging in relation to defined benefit pension schemes. When asset prices were rising companies took contribution "holidays" but now face the need to make sizeable contributions. The impact on corporate cash flow and therefore investment is significant and is one factor behind the current investment-led economic downturn.

Central bankers are struggling with how to incorporate asset prices into their interest rate policy decisions. There is full agreement that asset prices must be taken into account through their effect on the real economy and therefore the impact on future inflation. Hence both a boom and a slump in asset prices should be looked on with concern. However there is much less agreement on how or indeed whether to formalize a monetary policy rule incorporating asset prices. The Bank for International Settlements as well as national central banks are thinking hard about this issue at present but no consensus has emerged as yet. Meanwhile it often appears as though monetary authorities react more to a slump than a boom. But this carries the risk of ratcheting up asset prices to unsustainable levels.

One approach might be for central banks to consider setting "reference values" or "rational ranges" for asset prices, as the ECB does for money growth. Central Banks would not need to respond slavishly to departures from these ranges but the innovation might focus the markets more on a possible interest rate response to rising or falling asset prices and also help to ensure a more symmetric response. An alternative approach is to turn the focus back to credit growth, which is directly linked to asset values. It was the "financial repression" of the post-war years, which restrained credit booms and, arguably, helped to limit financial instability. The challenge now is how to limit such booms without once again repressing the financial sector, which would have real resource and allocation costs.

The importance of asset values is also crucial in bank regulation policy. The Basel II proposals are widely recognized as potentially pro-cyclical (i.e., encouraging more bank lending in the upswing and less in the downswing). Even without prescribed capital ratios there tends to be an inherent procyclicality in bank lending since it is closely linked to asset prices through the use of collateral. Charles Goodheart proposed at a recent SUERF Colloquium in Brussels, that bank lending should be rendered less risky by measures to slow it during an upswing and increase it during a downswing. This could be done by, for example, changing the mandated loan-value ratio for property loans according to the price of property relative to its long-term trend. On an ad hoc basis, Hong Kong has taken this approach in recent years but, again, the policy has been more prevalent in deflationary cycles than during inflationary ones.

The irony for the monetary authorities is that their very success in defeating inflation over the last twenty years has brought the issue of financial instability to the fore. While low inflation does help in preventing some sources of financial instability, it makes others worse because there is no respite from nominal debt contracts. Central banks, and not just the Bank of Japan, are terrified of letting the inflationary genie out of the bottle again in response to a debt deflation. But the answer may be that we need monetary policy rules that explicitly take account of asset prices.

John Calverley is Chief Economist of American Express Bank.