Monetary authorities need to keep an eye on changes in asset prices and - on occasion - to take action in response to such changes, controversial though that may be.
In the maintenance of monetary and financial stability, central banks and monetary authorities, including the financial regulatory authorities, have to monitor all relevant developments in the economy. Where circumstances require the taking of pre-emptive or corrective actions, within the powers of the authorities, to ensure monetary and financial stability, they will need to be taken decisively and transparently, and the background considerations leading to those actions will need to be clearly explained. This is rarely an easy task, for the actions are often controversial and involve inflicting (hopefully only short-term) pain on the community that the authorities serve.
One area that monetary authorities watch with increasing intensity is the movement of asset prices. In jurisdictions in which the objective of monetary policy is internal price stability, sometimes measured quantitatively by an inflation target, the attention given to asset prices seems prudent. Although normally the movements of asset prices are not directly built into consumer price indexes, by reference to which inflation is often measured, they invariably affect the inflation rate. In coming to a view on whether action is necessary and, if so, what action is to be taken, the authorities often have to make subjective judgements about whether asset prices have become too high or too low. And when action is taken, whether in the form of an interest rate adjustment or suggestive utterances of the "irrational exuberance" type, such a subjective view is either explicitly or implicitly made public. Depending on the degree of standing the authorities command, actions or statements of this kind have a tendency to get them into different degrees of trouble and to subject them to criticism. This is particularly so with those who take a rather dogmatic view about free markets and who just cannot accept that markets can and do overshoot, if not fail altogether in their fundamental price determination functions, and that excessive market volatility can have damaging consequences.
Take an example at the micro level and consider the stability of the banking system. Banks lend money accepted on deposit by customers on the security of assets. Prudent banks lend with a "haircut" on the current asset price and the haircut is estimated on the basis of the historical volatility of the price of the asset. The more sophisticated lenders may vary the size of the haircut, in accordance with their view of the probability of a sharp downward adjustment in the market price of the asset occurring at different times. But successful examples of this are rare and, for those able to do so, their views are more often than not incorrect - it is never easy to spot the turning points of markets and predict correctly the extent of adjustment in the market cycle. Sometimes it is necessary for the regulatory authorities to have prudential guidelines laid down to facilitate risk management, particularly when keen competition for the business has a tendency to lead banks to take greater risks. But inherent in this approach is considerable moral hazard. Market adjustments can overshoot even with conservative prudential guidelines, making the cushion provided by the guidelines inadequate and risking the erosion of capital adequacy of the banks. Alternatively, when the regulators adjust the guidelines, in the light of market developments, their action may precipitate the sharp market adjustments with which the guidelines are designed to cope.
There is no doubt that the asset prices have an important bearing on monetary and financial stability. This explains why central banks and monetary authorities give increasing attention to them. Indeed, there have been cases in which they act out of concern about the likely effects of sharp movements in asset prices on price stability or the integrity and stability of the financial system witness the comment on "irrational exuberance" and the interest rate cuts following the collapse of LTCM. Our own market intervention in August 1998 was made out of concern about the damaging effects on monetary and financial stability of the stock and futures market overshooting. And we got ourselves actively involved in the establishment and enforcement of the "voluntary" industry guideline of a 70% loan-to-valuation ratio for mortgages, which was lowered to 60% for a period for the luxury properties.
But a keen interest in the movements of asset prices, in the proper discharge of the responsibility of monetary authorities in the maintenance of monetary and financial stability, does not imply a desire to steer them in a particular direction or to usurp the role of the market in discovering them. It is necessary for monetary authorities to be very clear on this.
Joseph Yam
16 May 2002
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