Dangerous bubble fears

Here is Swedish central bank governor Stefan Ingves in an op-ed piece in the Swedish newspaper Svenska Dagbladet last week:

“I also have to take responsibility for the long term consequences of today’s monetary policy…And there are risks associated with an all too low interest rate over a long period, which cannot be ignored.”

Said in another way if we keep interest rates too low we will get bubbles. So despite very clear signs that the Swedish economy is slowing Ingves would not like to ease monetary policy. Ingves in that sense is similar to many central bankers around the world. Many central bankers have concluded that the present crisis is a result of a bubble that bursted and the worst you could do is to ease monetary policy – even if the economic data is telling you that that is exactly what you should.

The sentiment that Ingves is expressing is similar to the view of the ECB and the fed in 2008/9: We just had a bubble and if we ease too aggressively we will get another one. Interestingly enough those central banks that did well in 2008/9 and eased monetary policy more aggressively and therefore avoided major crisis today seem to be most fearful about “bubbles”. Take the Polish central bank (NBP). The NBP in 2009 allowed the zloty to weaken significantly and cut interest rates sharply. That in my view saved the Polish economy from recession in 2009 – Poland was the only country in Europe with positive real GDP growth in 2009. However, today the story is different. NBP hiked interest rates earlier in the year and is now taking very long time in easing monetary policy despite very clear signs the Polish economy is slowing quite fast. In that sense you can say the NBP has failed this year because it did so well in 2009.

The People’s Bank of China in many ways is the same story – the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.

So the story is the same in Sweden, Poland and China. The countries that escaped the crisis did so by easing monetary conditions. As their exports collapsed domestic demand had to fill the gap and easier monetary policy made that possible. So it not surprising that these countries have seen property prices continuing to increase during the last four years and also have seen fairly strong growth in private consumption and investments. However, this now seem to be a major headache for central bankers in these countries.

I think these bubble fears are quite dangerous. It was this kind of fears that led the fed and the ECB to allow monetary conditions to become excessive tight in 2008/9. Riksbanken, NBP and the PBoC now risk making the same kind of mistake.

At the core of this problem is that central bankers are trying to concern themselves with relative prices. Monetary policy is very effective when it comes to determine the price level or nominal GDP, but it is also a very blunt instrument. Monetary policy cannot – and certainly should not – influence relative prices. Therefore, the idea that the central bank should target for example property prices in my view is quite a unhealthy suggestion.

Obviously I do not deny that overly easy monetary policy under certain circumstances can lead to the formation of bubbles, but it should not be the job of central bankers to prick bubbles.

The best way to avoid that monetary policy do not create bubbles is that the central bank has a proper monetary target such as NGDP level targeting. Contrary to inflation targeting where positive supply shocks can lead to what Austrians call relative inflation there is not such a risk with NGDP level targeting.

Let’s assume that the economy is hit by a positive supply shock – for example lower import prices. That would push down headline inflation. An inflation targeting central bank – like Riksbanken and NBP – in that situation would ease monetary policy and as a result you would get relative inflation – domestic prices would increase relative to import prices and that is where you get bubbles in the property markets. Under NGDP level targeting the central bank would not ease monetary policy in response to a positive supply shock and inflation would drop ease, but the NGDP level would on the other hand remain on track.

However, the response to a demand shock – for example a drop in money velocity – would be symmetric under NGDP level targeting and inflation target. Both under IT and NGDP targeting the central bank would ease monetary policy. However, this is not what central banks that are concerned about “bubbles” are doing. They are trying to target more than one target. The first page in the macroeconomic textbook, however, tells you that you cannot have more policy targets than policy instruments. Hence, if you target a certain asset price – like property prices – it would mean that you effectively has abandoned your original target – in the case of Riksbanken and NBP that is the inflation target. So when governor Ingves express concern about asset bubbles he effective has said that he for now is not operating an inflation targeting regime. I am sure his colleague deputy governor Lars E. O. Svensson is making that argument to him right now.

I don’t deny that bubbles exist and I am not claiming that there is no bubbles in the Swedish, Polish or Chinese economies (I don’t know the answer to that question). However, I am arguing that monetary policy is a very bad instrument to “fight” bubbles. Monetary policy should not add to the risk of bubbles, but “bubble fighting” should not be the task of the central bank. The central bank should ensure nominal stability and let the market determine relative prices in the economy. Obviously other policies – such as tax policy or fiscal policy should not create moral hazard problems through implicit or explicit guarantees to “bubble makers”.

Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles. I doubt that the Riksbank, NBP or the PBoC will make the same kind of mistakes, but bubbles have clearly led all three central banks to become overly cautious and as a result the Swedish, the Polish and the Chinese economy are now cooling too much.

I should stress that I do not suggest some kind of “fine tuning” policy, but rather I suggest that central banks should focus on one single policy target – and I prefer NGDP level targeting – and leave other issues to other policy makers. If central banks are concerned about bubbles they should convince politicians to implement policies that reduce moral hazard rather than trying to micromanage relative prices and then of course focus on a proper and forward looking monetary policy target like NGDP level targeting.

PS Note that I did not mention the interest rate fallacy, but I am sure Milton Friedman would have told governor Ingves about it.
PPS You can thank Scandinavian Airlines for this blog post – my flight from London to Copenhagen got cancelled so I needed to kill some time before my much later flight.

Related posts:

Boom, bust and bubbles
The luck of the ‘Scandies’
Four reasons why central bankers ignore Scott Sumner’s good advice

Leave a comment


  1. Felipe

     /  October 22, 2012

    Hello Lars, Interesting post.

    I have a question though. Scott Sumner has told me in the comments of some of his posts that NGDP targeting is not really a good tool for smaller, open economies. In such an economy, if trading surges because of extra foreign demand, the central bank would be ill-advised to choke the local economy to maintain an overall level of NGDP. Conversely, if trade slows down, wouldn’t the central bank be ill-advised to stimulate local demand to make up for gone foreign demand?

    I think Sweden and Poland both have relatively large export sectors. Maybe the CBs would be ill-advised to further boost local demand?

    • Felipe, I do think Scott has a point. However, the problem is not really much different from inflation targeting. Take the extreme example of Iceland where basically all consumer goods are imported – should the Icelandic central bank really try to hit an inflation target in such environment?

      Maybe the solution for small open economies is to target the domestic demand level. That would basically be the same as NGDP level targeting.

      • fsateler

         /  October 23, 2012

        Maybe the solution for small open economies is to target the domestic demand level. That would basically be the same as NGDP level targeting.

        I presume you mean that it would be the same as NGDPLT for a large economy like the US.

        However, I’m curious about such a policy target. Is there some literature to be read on it?

  2. Alex Salter

     /  October 22, 2012

    I’m happy that folks are starting to realize relative prices matter even for business cycles, but as Sumner warns us, the nominal interest rate by itself is a very noisy signal of monetary tightness/easiness. What does Swedish real income growth look like?

  3. marksadowski

     /  October 22, 2012

    “So it not surprising that these countries have seen property prices continuing to increase during the last four years and also have seen fairly strong growth in private consumption and investments.”

    But property values have been generally falling in Poland for over four years. See for example this:


    So I don’t think Poland at all fits into your overall bubble narrative.

    And Poland only raised rates by a quarter point in May (from 4.5 to 4.75). In my opinion the weakness has simply hit the economy much faster than policymakers expected.

    P.S. Poland is undergoing considerable fiscal tightening right now and in my opinion the monetary authorities may have underestimated its effect.

    • Mark, broadly speaking the NBP is worried about what it did in the past rather looking forward. In terms of property prices we don’t have a good measure of property prices in Poland. However, I would see that things have turned rather bleak for the Polish property market in the last 3-4 months and not longer than that.

      It is correct that fiscal policy has become more tight recent, but in my view that is not really what is slowing the economy. However, I think the rate hike had a significant negative impact on expectations. It was not the 25bp cut that did it, but the fact that the NBP would be expected to tighten more going forward and ease less in the event of a slowdown that did it.

      My observation “on the ground” (I am quite often in Poland) is that the sentiment has turned decisively negative over the last half year. That coincides with the rates hike. The local media however would point to increased political uncertainty, some bankruptcies in the construction sector and the notorious “Amber gold” case.

  4. jpirving

     /  October 23, 2012

    Riksbankens apparent decision is maddening, Lars! Beyond the good economic reasons for cutting rates this week, they are failing to hit the mandated inflation target over the business cycle, as Svensson and my old professor Bengt Assarsson have shown. If they don’t cut rates in December and take a more active approach in accommodating future haven demand for the SEK, a lot of forecasters are going to look dumb in 2013…me among them…

    • JP, it would surely be interesting to participate in Riksbankens’s MPC meeting – lets justa say I think Lars EO is angry most of the time…

  5. fsateler, William Niskanen used to argue that the Federal Reserve should target “final sales to domestic purchasers.” (FSDP) This aggregate is equal to NGDP minus the change in private inventories minus exports plus imports. My suggestion is that small open economies should target a similar measure – I would call it domestic demand.

    In there might be good arguments that FSDP is a better aggregate to target than NGDP also for the fed. Bill Woolsey and Scott Sumner used to long discussions about this them. See for example here: http://monetaryfreedom-billwoolsey.blogspot.dk/2011/11/ngdp-vs-fsdp.html

  6. Leszek

     /  October 23, 2012

    If conventional monetary policy (interest rates) don’t work, unconventional measures have to be taken. But if these don’t work, and no one is willing to borrow all the reserves being stuffed into the banks, it is time for extraconventional monetary policy. For example: the FED should have printed massive amounts of money to buy a massive amount of American houses to prop up the housing bubble and the financial products dependent upon it. If people don’t want to borrow and spend, central banks have to do it. They even could buy consumer goods to keep nominal GDP stable.

  7. Ravi

     /  October 25, 2012

    Looks like Ingves has really confused the market now – first he signals tightening, and now the Riksbank may ease? What must Svensson make of all this…

  8. “Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles. ”

    Not according to R. Werner?

    See his ‘Princes of the Yen’ . and

    ‘The New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance’
    Richard D. Werner

  9. postkey

     /  September 6, 2015

    “Japan has been in a 15 year deflationary environment with falling asset prices and a primary reason for that is the Bank of Japan’s insane fear of creating bubbles.”

    Not according to Prof. R. Werner?
    See ‘Princes of the Yen’
    ‘The New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance’
    Richard Dr Werner

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