Wally: Pertinent part of Meyer's comments follows. I see nothing really new here. Maybe I am missing something. Here it is:
Let me move to the challenge of how monetary policy should respond to suspicions of asset
market bubbles. An asset market bubble refers to an extended increase in the price of assets not
justified by the fundamentals. Such movements might be associated with waves of optimism or
pessimism that become self-perpetuating.
There is not a complete agreement as to the usefulness of the concept of asset bubbles. I do find it
plausible that market prices might sometimes, and for some period, depart from values that are
justified by fundamental forces. Over longer periods, markets will converge back to fundamental
value. However, when large departures occur, there is potential for a sharp correction that, in turn,
can have damaging consequences for the real economy. There are two asset markets that are of
special importance. The first is the equity market and the second the market for real
property--land and buildings.
The fundamental value of a stock is the present value of the expected earnings stream of the firm in
question, derived by applying a discount factor that accounts for both the interest rate on safe
assets and a risk factor appropriate to the uncertainties about the expected future earnings stream.
The fundamentals underpinning the price of equities are therefore the expected increase in earnings
and the discount rate that transforms expected earnings into a price for the asset. Equity prices
could rise above their fundamental value if investors hold unrealistic expectations about earnings
growth, if they assume that the earnings stream is more stable than it will turn out to be, or if they
otherwise believe there is less risk associated with holding the equities than turns out to be the
case. In these cases, reality will at some point disappoint relative to expectations and force a
reappraisal of the value of equities. A similar process underlies the price of real property.
Monetary policy, as I emphasized earlier, focuses on price stability and damping fluctuations
around full employment. Should it also focus on encouraging asset prices to return toward
perceived fundamental value, if asset prices appear to depart significantly from policymakers'
perception of that fundamental value? That is another question tackled at the Jackson Hole
conference. It is one motivated by at least two recent experiences. First, the Japanese economy is
often described today as suffering from a burst in an asset bubble. During the 1980s, the Japanese
economy registered very strong growth, low inflation, and soaring equity and property prices. In
1989, following a tightening of monetary policy, there was a sharp collapse in asset prices. Equity
prices fell by 60 percent and urban land values by more than 75 percent.
In addition to direct effects via the decline in wealth on consumer spending, the collapse of asset
prices had a devastating effect on the banking system. Real property dominates the collateral
underlying many of the loans of most banking systems. A collapse in real property values,
therefore, leaves most loans without adequate collateral support. In addition, in Japan, the banks
hold considerable equities in their portfolios. Japanese banks therefore suffered a double blow in
the collapse of equity and property prices. As a result, with the capital of the banking system
severely depleted, banks had to restrict their lending, leading to a severe credit crunch that added
to the forces depressing the Japanese economy.
The second experience hits closer to home. Many have viewed the surge in equity prices in the
United States over the past four years as evidence of a bubble. The Economist magazine is a
leading proponent of this view, and many others subscribe in varying degrees to this
characterization. It is true that the rise in equity prices--averaging 25 percent to 30 percent a year
over the last four years--is unprecedented and that current values challenge previous valuation
standards. But one could argue that structural changes in the economy have raised the sustainable
level and growth of earnings and lowered the volatility of earnings or otherwise reduced the
perceived risk in equities. Such structural changes could, in principle, justify at least a substantial
portion of the rise in equity prices. But the question at issue here is whether policymakers should
substitute their judgment about fundamental value for the market's assessment and use monetary
policy to encourage a convergence back to their own estimate of fundamental value.
The paper by Bernanke and Gertler at the Jackson Hole conference addressed this question. They
used a methodology that has proved valuable in studying a number of other questions related to
the strategy of monetary policy. They first construct a small model of the U.S. economy and then
subject this model to a series of disturbances that reflect the economy's historical experience. They
observe the resulting variability of inflation and output relative to their respective targets. The base
model includes a policy rule according to which short-term interest rates are adjusted in response
to economic developments. Bernanke and Gertler examine whether an attempt by policymakers to
return equity prices toward their estimate of fundamental value improves macroeconomic
performance, judged in terms of inflation variability and output variability. Confidence in their
conclusion is, of course, affected by how well one believes the model captures the performance of
the economy. Nevertheless, their methodology is well designed and it is worth considering their
conclusions.
They find that policymakers cannot improve the outcomes by responding directly to suspected
deviations of equity prices from fundamentals, but that a policy focused on achieving price stability
and damping fluctuations around full employment will mitigate the adverse consequences of equity
market bubbles. That is, a monetary policy focused on price stability and output stabilization will
respond to the effects of higher equity prices on aggregate demand, real economic activity, and
inflation. This will generally dampen movements in equity prices, while contributing to meeting the
broader macroeconomic objectives of monetary policy. However, given the difficulty in
distinguishing between changes in asset prices dominated by fundamental forces and those driven
by non-fundamental forces, policymakers should not target asset prices or try to guide them to the
policymakers' estimate of fundamental value.
The discussion of the paper by Rudy Dornbusch and comments by Federal Reserve Chairman
Alan Greenspan added an important additional theme related to monetary policy and equity
prices. Dornbusch took note of the setting, pointing out that the two sides of the Teton Mountains
are dramatically different. One side slopes downward gradually and gracefully. The other side
drops off quite precipitously. So it is with equity prices. On the way up, they typically move
gradually. While they sometimes also move downward gradually, downward movements are
occasionally steeper and more discontinuous than upward movements. Monetary policymakers
sometimes face additional problems in the case of such steep declines in asset values. Credit
markets may become extremely illiquid and even fail to operate for a period. It is not simply that
interest rates on private securities rise, but that virtually all buying and selling may temporarily
cease. This can create extreme problems for those who rely on short-term financing and, in the
extreme, the resulting financial distress can threaten the solvency of some financial institutions. In
such situations, monetary policy typically intervenes to provide liquidity, until markets recover and
begin to operate more normally.
Because of this, it is sometimes alleged that monetary policy stands ready to intervene to protect
market prices in a downturn. Chairman Greenspan commented that markets are asymmetric, not
monetary policy. He emphasized that monetary policy does not operate with a target for equity
prices when they are falling any more than it does when equity prices are rising. In both cases,
monetary policy responds only indirectly to equity prices, by taking equity prices into account in
the assessment of aggregate demand. But monetary policy has to respond quickly to the special
circumstances that accompany a collapse of asset values, specifically the extreme illiquidity and
seizing up of credit markets. This occurred both in 1987 and, more recently, in the fall of 1998.
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