The Third Mandate and Stabilit

Speaking on CNBC at a FDIC sponsored forum last week, FED chairman Bernanke was asked how quantittative easing could be called a success in view of rising interest rates and commodity price spikes. His answer revealed that the FED now officially admits having a third mandate : "Our policies have contributed to a stronger stock market, just as they did in March 2009 when we did the last iteration of QE. The S&P 500 is up 20% and the Russell up 30% plus"

The original FED mandate exists out of two mandates : low inflation/price stability and growth/full employment. This seems simple enough but in reality, both targets are very hard to achieve simultaneously. Unless some successful supply side policy is achieved, most outcomes with accelerating growth are accompanied by demand side price pressure, hence generating inflation. The third mandate now seems to be asset price targeting, or, at least a monetary policy which supports asset prices and prevents asset prices of movingsouth.

The debate is not new and came to the forum early last year. At that point, central bankers in Europe and some emerging markets considered the idea of asset price targeting, but from a different perspective : should monetary policy also consider asset prices as price targets ? And accordingly, should central banks adjust monetary policy - by ways of tightening - in order to prevent asset prices of moving too quicklynorth (bubble) ? The debate was early on blocked by Anglo-saxon forces, merely stating that you don't have the technical tools to achieve this and you can't pinpoint whether a bubble is in the making or not. If this is true, it seems very odd that the FED now considers of having the tools nevertheless. And in addition, it is succesful in implementing asset price targeting policy. Briefly, a pre-emptive strike to avoid bubbles is impossible, a pre-emptive strike to support asset markets is possible ?

Next to the usefulness of a third mandate, another important question comes to mind : What lies beneath or why ? I cannot escape the feeling that the rationale behind the Bernanke comment is the following : When asset prices go up, people feel wealthier, are no longer risk averse and start spending again. This psychological effect creates a positive upward spiral with growth and employment following suit. This is not new, in fact, monetary policy since Greenspan (and his put) has always been percieved like this. The big question however is should peoplefeelwealthier and is the economy served by this ? I am not a fan of Milton Friedman but some of his insights on consumer behavior are worth taking a look at. His permanent income hypothesis briefly states that people consume a constant proportion of their longer term planned income. Transitory income (windfall profits, one-offs) don't or should not play a role. To some extend it goes back to Ricardian equivalence : when people receive apresent from the tax man and governments create debt, people don't go out spending right away : They most like save a part of the windfall profit because they know that somewhere in the future, the tax-man will come along to levy taxes to pay off the debt. Back to the "feel wealthy" argument : it seems the American Dream pops up again, with monetary policy trying to convince people that asset prices can only go up so "feeling wealthy" becomes a part of "permanent income". The recent housing bubble accompanied by the equity withdrawal credit habit of the US consumer is also a perfect example.

History shows that this kind of dream cannot last forever. And the benefits for the economy in the medium term are also questionable. A final argument is that this kind of policy is bound to create volatility. And volatility is not what Wall Street nor Main Street needs. The German based their philosophy of "Stabilität"following 1 ugly experience in 1923 called hyperinflation. Since then, the German point of view is that macro policy should be conceived in such a way that it prevents strong deviations from trend growth. Simply put : "Yes" to small positive/negative surprises, "No" to shocks, be it north or south. And if you look at real consumer expenditure in Germany over the past decades, it barely budged over various business cycles. A second argument for Stabilität is the following : it is fairly easy to create something which skyrockets, you only need to print the money press like hell and create budgetary deficits. But once this policy leads the economy in going deep south,it becomes very difficult to get on trend growth track again. And the pendulum is bound to go wider and wider once the same policy errors of the past are repeated, overshooting intensifies and becomes a permanent part of daily life.

Asset price targeting is an interesting debate and deserves attention. And whether you like the Germans or not, they often provide useful insights on how to avoid economic trouble further up the road.