By Steven K. Beckner

JACKSON HOLE, Wyo. (MNI) – The Federal Reserve should consider
paying more attention to credit growth and less to inflation forecasts
in setting monetary policy, according to a research paper presented
Friday to the Kansas City Federal Reserve Bank’s annual symposium.

The four economists who wrote the paper contend that, “An interest
rate rule that assigns too much weight to expected inflation can induce
welfare-reducing volatility in the stock market.”

The authors are Lawrence Christiano of Northwestern University and
the National Bureau of Economic Research, Cosmin Ilut of Duke
University, Robert Motto of the European Central Bank and Massimo
Rostagno, also of the ECB. Their paper is being introduced to an
all-star cast of central bankers, including Fed Chairman Ben Bernanke.

Typically, the Fed has based its interest rate decisions on its
forecast of inflation, not on the growth of credit aggregates. When
inflation is low and expected to be low, the Fed has tended to keep
interest rates low or even reduce them, as in the earlier part of this

But that approach may be just the opposite of what is needed,
according to the paper.

After studying 18 U.S. stock market booms over the past 200 years,
they find that they are nearly always accompanied by rapid credit
expansion but not by increased inflation. Credit grows twice as fast in
boom times than in non-boom periods, they say.

“The historical record suggests that, at least at an informal
level, a monetary policy which implements inflation forecast targeting
using an interest rate rule would actually destabilize asset markets,”
the economists write. “The lower-than-average inflation of the boom
would induce a fall in the interest rate and thus amplify the rise in
stock prices in the boom.”

Rather, the Fed might better pay more attention to credit growth,
they write, noting that in all but two booms “credit growth is always
stronger during a boom than outside a boom. On average, credit growth is
twice as high in booms than it is in non-boom periods.”

But because the Fed focuses primarily on inflation, it
underestimates the importance of this credit growth they suggest.

“Casual reasoning suggests that volatility would be reduced if
credit growth were tightened as booms get underway,” write Christiano et
al. “In practice, this tightening in response to credit growth would not
be justifiable based on the inflation outlook alone because booms are
not in fact periods of elevated inflation.”

But they go on to present research that supports the idea that
“credit growth should be assigned an independent role in monetary

The authors do not oppose inflation forecasting or even inflation
targeting, but warn that using an inflation target as part of an
interest rate targeting rule, such as a Taylor Rule, can cause problems.
Under a Taylor Rule, the central bank cuts interest rates to the extent
expected inflation undershoots an inflation target and raises rates if
inflation exceeds the target.

Under some circumstances, such as a technological innovation that
increases productivity, expected and in turn current inflation can
decline. Yet, at the same time, expected returns to capital in the
future can rise due to the increased productivity, and that can fuel
increased demand for goods and services and push up asset prices.

Such a “productivity shock” should cause an increase in the
“natural” or real equilibrium rate of interest, which the Fed should
take into account in setting nominal interest rates, they maintain. And
they say credit growth is a “good proxy” for the natural rate.

But instead of adjusting rates higher, the paper notes, the
tendency has been for the Fed to hold rates down, thereby fueling booms.

“The problem with the inflation forecast interest rate targeting
rule is that it reduces the interest rate in a boom triggered by
optimistic expectations, while the efficient monetary policy would
increase the interest rate,” they write.

“Our analysis does not challenge the wisdom of inflation targeting
per se, only the effectiveness of doing so with an inflation forecast
interest rate targeting rule that is principally driven by the inflation
forecast,” they add.

The paper uses an econometric model to investigate whether
“assigning a role to credit growth — beyond its role in forecasting
inflation — may help to stabilize booms.”

“The inflation forecast interest rate targeting rule causes the
economy to over-react to the optimism about the future, though inflation
during the boom is low,” they find. “The natural rate of interest rises
sharply in the model.”

“When we assign a separate role for credit growth in the interest
rate rule, then the response of the economy is more nearly optimal,”
they continue. “We interpret this as signifying that credit growth is a
reasonable proxy for the natural rate of interest.”

“We find that when we allow credit growth to play an independent
role in that rule, one that goes beyond its role in forecasting
inflation, then the interest rate targeting rule’s tendency to produce
excessive volatility in response to optimistic expectations about the
future is reduced,” the authors go on. “We interpret this as evidence
that credit growth is correlated with the natural rate of interest.”

“The natural rate of interest is what one really wants in the
interest rate targeting rule, and credit growth appears to be a good
proxy, at least relative to shocks to expectations about the future,”
they add.

Under prevailing policy doctrines, the authors allege, the Fed is
feeding rather than containing asset price booms.

“In sum, an interest rate targeting rule that assigns substantial
weight to inflation transforms what should be a modest expansion into a
significant boom,” they write. “The reason is that the monetary policy
does not raise the interest rate sharply with the rise in the natural
rate of interest.”

They say “this problem can be fixed by setting the interest rate to
the natural rate or, if that is deemed too difficult to measure, to some
variable that is correlated with the natural rate.”

In their conclusion, Christiano and company write: “We have
reviewed evidence which suggests that inflation is typically low in
stock market booms and credit growth is high. The observation that
inflation is low suggests that an interest rate targeting rule that
focuses heavily on anticipated inflation may be destabilizing. The
observation that credit growth is high in booms suggests that if credit
growth is added to interest rate targeting rules, the resulting rule
will tend to smooth out stock market fluctuations.”

** Market News International **

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