Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 12 June 2014

John Williams on bubbles and monetary policy

I have always found what John Williams writes interesting, from long before he became president of the Federal Reserve Bank of San Francisco. So this post just reviews a speech he recently gave at the Bundesbank’s delightful conference centre on the banks of the Rhine. For me he said three interesting things.

1) He first emphasised the dangers of deviating from monetary policy’s primary goals because of a concern about financial stability. What was interesting for me is that he did this by example, looking at what had happened in Sweden and in Norway. Now my impression is that central bankers do not make a habit of publicly criticising their colleagues in other countries, but Williams’ verdict is hardly nuanced. He is particularly concerned that inflation expectations in those countries have fallen sharply away from the target. (I discussed the dangers that could arise from this here.) He concludes “If the anchor were to slip, it would wreak lasting damage to a central bank’s control over both inflation and economic activity, at considerable cost to the economy.” We are used to hearing this about positive deviations of inflation from target, so it’s nice to hear it applied equally to negative deviations (ECB please note).

2) He then talked about asset market bubbles. What he had to say was not too controversial, but it is of immediate relevance to the UK. After looking at some persuasive empirical evidence, he said:

“Low interest rates boost fundamental valuation of assets. In a world of rational expectations, asset prices adjust and that’s it. But, if one allows for limited information, the resulting bull market may cause investors to get “carried away” over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices.”

Recently I talked about how expectations of a prolonged period of low real interest rates could lead to sharp increases in house prices, as we have recently observed in the UK and elsewhere. What Williams is suggesting is that this process can lead to overshooting, as the market gets carried away.

3) All this seems to be leading to the inevitable discussion of macroprudential controls rather than interest rates to deal with overshooting of this kind. He says “monetary policy actions should only be a last resort.” But then his discussion took an unexpected turn, for me at least.

“One of monetary policy’s most important lessons—borne out in both theory and practice—is that the framework for policy is more important than the details of the execution. In terms of price and economic stability, anchoring inflation expectations and responding in a systematic way to economic developments are by far the most important elements of good monetary policy.
 Instead of thinking about how monetary policy should respond to risks to financial stability, we should focus on studying ways to design policy frameworks that support financial stability with only a modest cost to macroeconomic goals and anchoring inflation expectations.”

What does this mean? He is careful to say “I am not personally advocating either of these proposals, but I do view them as creative ways to think of how to bend the curve in terms of macroeconomic and financial stability tradeoffs.” Well one of the two ideas he notes is that monetary policy should target nominal income rather than inflation. “The idea that nominal income targeting could be supportive of financial stability is relatively straightforward (Koenig 2013, Sheedy 2014).” The paper by Koenig [1] I did not know, but the paper by Kevin Sheedy [2] I discussed over a year ago in this post. You read it here first!

[1] Koenig, Evan F. 2013. “Like a Good Neighbor: Monetary Policy, Financial Stability, and the Distribution of Risk.” International Journal of Central Banking 9(2, June), pp. 57–82.

[2] Sheedy, Kevin D. 2014. “Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting.” Presented at Brookings Panel on Economic Activity, March 20–21.


  1. What evidence is he talking about here:

    "“One of monetary policy’s most important lessons—borne out in both theory and practice—is that the framework for policy is more important than the details of the execution."

    This is an item of belief among central bankers - that rules-basedness is a massive desideratum in and of itself - but I don't really think it's all that well established at all. The "theory" he's talking about is basically Kydland & Prescott and all that came after, but what's the "evidence"? Surely the contrast between Trichet-ECB and Draghi-ECB shows that better execution can have massive effects in a largely unchanged policy framework.

  2. A friendly advice from an enthusiast follower of your blog: I think it would be more convenient if you set your references within your articles to open in a new tab/window!

  3. Yes, of course the interest-rate-lowering central bankers (and certain macroeconomists) don't want to be criticised for the asset bubbles they have created. Apparently *other* action is supposed to rein in the bubbles. But there's no such thing as a free lunch; and if other action reins in the increases in asset prices (in housing, stocks, bonds), they will simply counteract perfectly the stimulative effect of the interest-rate cuts.

    Perhaps it is there in the speech, it would be nice if there was a certain mea culpa about how the interest-rate cuts have led to greater inequality.

  4. That divide between an independent central bank and the government of representative democracy just got more interesting if the BoE gets to set mortgage level ratios.

    It was nice also to hear Nigel Lawson this morning, fresh from the Areopagus, welcome the apparently imminent rise in interest rates.

  5. If you make the reasonable assumption that central banks have no ability to spot bubbles, then a mandate to prevent bubbles is only going to result in more policy errors.

  6. I hope Yellen doesn't raise rates a year from now. There will be pressure on her to raise rates earlier. So there is no inflation or wage pressure there will be talk of "financial instability."

    The people who worry about that should be pushing macroprudential measures. Instead they seem intent on keeping the job market slack, which only increases inequality.

  7. "If you make the reasonable assumption that central banks have no ability to spot bubbles,"

    Why would anyone consider this to be a reasonable assumption?


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