Why stable prices and stable markets are important and how they fit together

Professor Otmar Issing, First Conference of the Monetary Stability Foundation, 5 December 2002, Frankfurt/Main

The subject of this panel discussion why stable prices and stable markets are important and how they fit together is indeed a very broad one. I therefore choose to restrict my comments to four issues. First I will quickly discuss what is a reasonable definition of price stability and remind us of its importance for overall economic performance. Second, I will briefly characterise a stable or well-functioning market mechanism. In doing so I will highlight the dynamic aspects of stability. Then I will elaborate on the general relationship between stable prices and stable markets. At this point, I would imagine, my statement will not have triggered much controversial discussion neither among my distinguished colleagues on this panel nor among the experts participating in this conference. But this might change during the fourth, final and main part of my statement, in which I will apply the general theme of this panel to one very specific market - the market for financial assets - and discuss the relationship between price stability and financial market stability. To be more concrete, I intend to focus on one particular and most interesting branch of the current literature, which claims that we have entered a new regime in which central banks' victory over general price inflation comes at a price. The alleged price is that a low inflation environment is conducive to more financial instability in the shape of boom and bust asset price cycles. As a consequence, it is pretended in the literature, central banks have explicitly to react to the build up of financial imbalances. I will argue later on - and I would be surprised if anyone in this room is surprised - that I am not convinced about the detrimental effects of low and stable inflation nor of the need to change the focus of our monetary policy strategy. I will rather try to convince you that the ECB's monetary policy strategy is sufficiently robust to deliver optimal monetary policy decisions even in a new regime environment. I assume that at this point few of you will complain about a lack of controversial issues for discussion, in which case I would have successfully played my role as a panelist.

Defining stable prices

Let me start by defining what can be meant with stable prices. Obviously stable prices can only mean a stable price level ^[1] or a low level of inflation and not stable individual prices. Stable individual prices would erode the advantages of a market economy. Or as Hayek argued convincingly "because all the details of the changes constantly affecting the conditions of demand and supply of the different commodities can never be fully known, or quickly enough be collected and disseminated, by any one centre, what is required is some [thing]…, which automatically records all the relevant effects of individual actions, and whose indications are at the same time the resultant of, and the guide for, all the individual decisions. This is precisely what the price system does under competition and which no other system even promises to accomplish." ^[2] There is no doubt that signals stemming from changing relative prices are a most crucial and beneficial input to economic decision making.

In this regard a related issue directly concerning monetary policy is the possibility of sectoral or regional differences in inflation within a monetary union. The issue is whether the existence of a target for low inflation for the whole union, for example below 2%, does not entail the structural risk of deflation in certain regions. With regard to the threat of deflation, one should not confuse relative price adjustments with overall changes in the price level. As I have dealt with this and the problem of deflation in general in a speech in London early this week (which is available at the ECB website ^[3] ), I just want to say that we currently see no risks for deflation in the euro area. Inflation forecasts of major international institutions and financial market participants confirm this view.

Even if a reduction of prices were to occur at some point in the future in any individual country of the European Monetary Union, its consequences would be very different from those of deflation in the whole area. The zero bound on nominal interest rates, to mention an often-quoted problem related to deflation, would not be binding in the first case for the euro area as a whole ^[4] .

I mentioned that stable prices can only mean a stable price level or a low rate of inflation. I will not dwell on the issue which of the two then is to be preferred ^[5] . Let me say only so much that this depends on the weight you attribute to the existence of nominal rigidities, and transition costs from one to the other regime on the one side and the general benefits of higher price level certainty and the lower probability to remain stuck in a prolonged deflation on the other side. Nominal downward wage rigidities favour a low inflation definition, which is

Tobin's ^[6] "grease the wheels of the economy" argument, while a price level objective would increase the probability that a negative real interest rate can lead the way out of a prolonged deflation due to a higher credibility of the central bank's commitment to future inflation ^[7] . As you all know, the ECB has opted to define price stability as an annual increase in consumer prices of less than 2%, to be achieved over the medium term. We thus have chosen the low inflation definition. The decision not to centre the definition of price stability around zero is due to possible measurement bias, likely problems at the lower bound of zero nominal interest rates and again the possible existence of nominal wage rigidities.

Costs of inflation

I would not be a "top to toe" central banker, when I would miss the opportunity provided to me by the title of this panel to remind us why price stability is important for economic performance. As this is largely known territory, a short list of the costs of inflation will be sufficient ^[8] . Among the best-known costs of anticipated inflation are the so-called "shoe- leather" costs, which are the search costs incurred whilst looking for alternative stores of value to real money balances, which do not bear interest. Second, menu costs assume a fixed cost every time prices are changed, and higher rates of inflation require a higher frequency of price changes. Third, non-indexed fiscal systems increase the distortionary effects of taxation by bracket creep and by reducing the after-tax return of investments - for example, when depreciation allowances are not adjusted for inflation. Fourth, residential property might be discouraged when anticipated inflation shifts the real burden of fixed nominal mortgage payments closer to the present time. Fifth, inflation in the presence of nominal rigidities as formalised in Taylor contracts or Calvo pricing produces costs due to relative price distortions. Let me finally add that in dynamic general equilibrium models inflation creates inefficiencies in distorting agents' decisions on the choice between labour and leisure and on the size of investments in financial services ^[9] .

Due to the predominance of nominal contracts unanticipated inflation creates costly real effects. The costs encompass wealth redistribution effects from creditors to debtors, thus possibly from old to young agents. Second, uncertainty about future inflation will distort investment decisions towards real assets and eventually reduces the overall level of investment. Third, Lucas' ^[10] misperception theory points out that inflation puts a veil on relative price signals and is likely to lead to resource misallocation.

Empirical estimates concerning the size of these costs vary, but the literature ^[11] hardly leaves a doubt about the general conclusion that empirical evidence confirms significant welfare costs of inflation. Let me also mention that calibration results from more recent dynamic general equilibrium models tend to produce rather larger costs of inflation than we are used to find in traditional partial equilibrium type of analysis ^[12] .

Defining stable markets

Let me turn to the second part of the title and briefly elaborate on one possible definition of stable markets. Obviously a stable market has nothing to do with a market where prices and transacted volumes are constant, rather the contrary is true. I would define a market as stable when it produces an efficient economic outcome. An efficient economic outcome would be attested when the following functions can be confirmed.

Note that the market structure itself is not important, although in general it is much more likely that the above functions will be fulfilled under perfectly contestable markets. In a stable market so defined, the price mechanism can fully play its allocation and information role. I would also consider the dynamic adjustment ability as crucial, which in turn is the key constituent element of a functioning market economy.

In the following I will discuss the relationship of stable prices and stable markets referring to the example of financial markets. Thus let me already here introduce financial markets as an illustration of the above definition. Financial markets provide the means to allow agents to shift consumption over time. Their existence as such is thus already welfare improving. A stable financial market should ensure the efficient allocation of savings to investment opportunities. A stable financial market should be able to accommodate financing needs and provide risk-sharing opportunities also in face of significant technology shocks (e.g. product innovation, liberalisation) and demand shocks (e.g. change in relative risk premium) without major disruptions. The incentives for producers of financial services should reward prudent risk management and lead to continuously improving investment and financing vehicles. Financial markets are special in the sense that the time dimension and thus the dynamic definition of stability is obviously crucial. Financial market prices - in the first place interest rates - link the present to the future being themselves largely determined by time preferences. Current asset prices depend on present values of expected future returns and constitute a claim on future consumption. It follows that instability encountered in financial markets will almost by definition affect a host of intertemporal contracts, with possibly wide ranging externalities.

and how they fit together

I turn now to the third part of the title. What is then the relationship between stable prices and stable markets? Let me first mention that the Austrian school - contributors like Hayek, von Mises and Lachmann - perfectly anticipated Lucas misperception theory. Lachmann ^[13] , for example, explicitly mentioned that inflation confuses the signals send by individual price changes. With inflation, prices still transmit information but incomplete information, which has to be interpreted. And according to Hayek persistent deviations from static equilibrium can be attributed to constantly changing information imperfectly conveyed between agents whose knowledge is different ^[14] . Thus a straightforward interpretation of the Austrian school is that inflation can prevent the market mechanism of providing an efficient resource allocation. Actually inflation could negatively affect all three functions, which I used in the definition of stable markets. As already mentioned, inflation disrupts efficient resource allocation due to the aggravation of the asymmetric information problem. Inflation furthermore disturbs the adjustment of supply to changes in demand due to veiling relative price signals. And finally, inflation could stall technological progress by diverting entrepreneurial effort towards hedging and exploiting the effects of inflation. Thus on this abstract level I would claim that inflation has the potential to destabilise otherwise stable markets.

Turning again to the more tangible example of financial markets, the conventional wisdom is completely in line with the view that inflation increases the likelihood of misperceptions about future return possibilities. Inflation, for example, deteriorates the asymmetric information problem between lenders and borrowers. A business cycle boom accompanied by high inflation is traditionally considered as the typical environment in which real over­ investment and asset price bubbles blossom. Excess liquidity provided by the central bank is one of the main factors for the development of inappropriately lax lending standards. After excessive return expectations failed to realise and the bubble bursts, missing then to accommodate the demand for liquidity in the economy will exacerbate the crisis especially when deflation could trigger a Fisherian vicious debt-deflation cycle ^[15] . Inflation is followed by deflation, or: stable prices play an important role for stable financial markets.

Strong protagonists of this view even claim that price stability is almost a sufficient condition for financial stability ^[16] . Others are more careful and simply state that price stability will tend to promote financial stability ^[17] . I think it is difficult to argue against the basic notion of the latter. Price stability and financial stability both cannot be achieved in a sustainable way one without the other. They tend to mutually reinforce each other in the long run. This widespread view is supported by empirical evidence that many financial crises were caused by major shifts in the price level ^[18] . From a conceptual monetary policy perspective, this situation is relatively benign. At each point in time the central bank would attempt to maintain price stability ^[19] . This is the best guarantee to simultaneously foster financial stability ^[20] . If successful, the central bank would prevent the build-up of financial imbalances in the first place and in case of a crisis, supplying liquidity would prevent deflation and stabilise the financial system. Moreover, historically most banking crises occurred during recessions ^[21] . This is comforting for central bankers in the sense that the likely policy stance to maintain price stability will also be appropriate for the state of the financial system.

On the other hand we also know that the world is not always as well behaved as we would wish it were. We know that financial imbalances can build up even in an environment of stable prices - think for example of the US in the 1920s and 1990s and Japan in the late 1980s. Thus we must be aware that price stability is a necessary but not a sufficient condition for financial stability. This means that if the central bank has a primary objective to maintain price stability over the medium term, simply pursuing an inflation targeting strategy according to an inflation forecast of one or two years horizon might not be the optimal policy strategy. The first inflationary and later deflationary pressures associated with developing financial imbalances might not receive the appropriate weight in the forecast. Optimal monetary policy cannot avoid that, at times, strains in the financial system might be such that deviations from simple inflation targeting have to be accepted in the short run, in order to preserve price stability over the medium to long run ^[22] . Indeed, this is one of the reasons why the ECB has always stressed that its two pillar based monetary policy strategy is more - and especially more robust - than simple inflation forecast targeting. I will come back to this point at the very end of my presentation.

New challenges to the traditional view: a new regime of central banking?

I will spend the remaining time discussing some recent ideas concerning the role inflation plays for financial market stability. It has been suggested that the conventional wisdom that price stability is good for financial stability has to be reversed. This - at least for central bankers of my generation - provocative view, has been presented in several very recent BIS research working papers but is also spreading in the academic world ^[23] . Interestingly, very first signs of a discussion along these lines can be found in the FOMC minutes of the November 13, 1996 meeting, a few weeks before Chairman Greenspan made his famous "irrational exuberance" speech. During the FOMC meeting Governor Lindsay mentioned being preoccupied by the thought that the central bank's success of keeping inflation under control could trigger a too optimistic outlook on the future course of economic development. Peoples' false sense of security could lead to asset valuations, which could pose problems for the future. He said that "either the (stock) market will stop rising or we will have to decide whether we are going to make it stop by injecting a little risk into the process. And, frankly, I think that call is going to be our toughest decision in the years ahead." Since then additional arguments have been forwarded to explain how "low and stable inflation can make the system more vulnerable to booms and busts…” ^[24]

In this recent literature ^[25] it has been argued that the inflation process has undergone a structural change. First of all, firms pricing power has been significantly reduced due to global competition. Second, positive supply side developments like the reduction of marginal costs due to faster growth of total factor productivity and labour market reforms have subdued inflation. And third, inflation expectations by the public at large have been anchored at very low levels due to the success of central banks monetary policies. This environment is meant to describe a new regime for central banking, in which it became much more difficult to conduct pre-emptive monetary policies. The reason is that for quite some time inflationary pressure might not show up in inflation itself, due to the mentioned low pricing power of firms, positive supply side developments and well anchored low inflation expectations. It has been argued that central banks' focus on price stability is insufficient and financial imbalances would have to be addressed directly. This direct response could consist of two parts. It would first involve trying to avoid (or at least subdue) the building up process of financial imbalances and second - if the former was unsuccessful (or insufficient) to smooth the adverse consequences when imbalances are being unwound.

Also Chairman Greenspan seems to subscribe to some degree to this analysis, although he rejects the policy recommendation to attempt to burst a developing bubble. In his remarks at the 2002 Jackson Hole symposium, he mentioned that "accumulating signs of greater economic stability over the decade of the 1990s fostered an increased willingness on the part of business managers and investors to take risks with both positive and negative consequences." Then he continued "nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost an illusion." ^[26]

I share Chairman Greenspan's concern about the feasibility of pricking an asset price bubble without triggering a severe recession. But let me raise a few other critical remarks with regard to this view on the suspected perils of low inflation and the suggested new regime for central banking.

First, are we sure that low inflation has really been the cause or at least one of the causes of recent financial imbalances, by which I mean the boom and bust share price development in the major stock exchanges in the last six years? At least two other developments occurred simultaneously, one of which is the positive supply side shock usually referred to as the new economy. Should realised and/or expected productivity gains associated with the new economy have been largely overrated by investors, this could alone explain the asset price bubble. It is not clear what was the part - if any - of subdued inflation in triggering collective euphoria. A second candidate is financial liberalisation and integration. Several authors have pointed to the fact that only in the 1990s was financial liberalisation and integration advanced to an extent that compared to previous decades we observed huge increases in cross-border portfolio and direct investment flows ^[27] . Financial liberalisation itself could be one factor, triggering investors' excessive optimism or inviting misallocation of resources ^[28] . A well- documented example of the possibly detrimental effects associated with the changeover to a regime of liberalised financial markets is the dismantling of international capital controls in Japan in 1979 ^[29] . The seed of the financial imbalances in Japan were rather the transition problems associated with financial deregulation than low inflation. Baring further evidence, I would be hesitant to include low inflation among the prime suspects for triggering excessive optimism. The claim that correlation can be interpreted as causality in this particular case seems premature to me.

Second, the new regime view implicitly assumes that investors do not learn and will continue to behave irrationally. If it turns out that low inflation really contributed to an overly optimistic investment climate, nothing guarantees that next time this has to happen again. We should not forget that the recent years of low inflation so far do not represent more than a relatively short episode in modern economic history. Thus some adjustment costs could be expected. For example, the lengthening of planning horizons in a low interest rate environment, certainly has positive economic effects in the long run, but could introduce a particular kind of uncertainty related to inexperience with discounting events further away in the future. But one would expect that an appropriate risk premium would soon be reflected in prices. Investors might learn and realise that a benign outlook for short-term inflation must not imply that higher equity valuations are necessarily fundamentally justified. Investors might forego this particular fallacy next time.

Third, assume the inflation process would really have changed on a permanent basis so that inflationary pressures - visualised by rising inflation figures - remained subdued for a long period of time. It is even then not obvious that we would need to speak of a new regime for central banking. Would it not be sufficient for a central bank to make sure that monetary policy is sufficiently forward-looking? This would imply that the outlook for future price stability is based on indicators, which are able to detect any currently subdued inflationary pressure. Again one could think as an example of monetary and credit developments. Obviously this raises a political problem, which is that it might be difficult for a central bank to tighten its policy stance as long as no evident signs of inflation are visible. Providing and safeguarding a central bank's independence from the political sphere might be the best way to attack this problem.

Fourth, even thinking about the latest boom and bust period in equity prices, we should not be too sure that imbalances had absolutely to be avoided. In his book "Famous first bubbles" Garber ^[30] has argued convincingly that one should never prematurely interpret the failure of macroeconomic experiments as proof that investors were foolish and irrational. Investors had to position themselves in a new environment and come to an evaluation of success probabilities. In a situation where even among experts disagreement about the correct measurement, source and effects of productivity growth were widely debated, this has been a challenging task for the private sector as well as central banks. I have high esteem for the staff at the Fed or the Eurosystem, but I can see no reason why a central bank should be better positioned than market participants in carrying out these evaluations. Obviously one could discuss to which degree a central bank would need to know whether a bubble is a bubble or whether it would not be sufficient to react to some leading indicators of financial distress ^[31] . The latter appears to be a more reasonable suggestion, worthy of further research.

Fifth, the policy conclusion to be drawn from the claim that low inflation increases financial instability is not clear to me and could potentially be dangerous. Should a successful central bank on purpose create higher and more volatile inflation, in order to remind investors that central banks can spoil a party?

Finally let me briefly analyse how the ECB's monetary policy strategy is constructed to deal with this challenge. There is ample empirical evidence that financial imbalances are created by means of extensively leveraged investments and thus are reflected in the credit demand of the private sector and credit is one of the counterparts of M3. Thus a monetary policy strategy that monitors closely monetary and credit developments as important driving forces for consumer price inflation in the medium and long run - as done under the ECB's first pillar -as an important side effect also contributes to limiting the emergence of unsustainable developments in asset valuations. Monetary aggregates and credit developments in situations of financial instability can signal to what extent consumption, investment, labour and price setting decisions are affected by conditions of financial disorder, excessive euphoria or disillusion. And a central bank would be badly advised not to exploit this source of information.

In times of financial distress, the assessment of the first and second pillar could give different signals. In the first place, and this not a minor aspect, this result would ask for increased caution on monetary policy decisions. Should the development of financial imbalances be -obviously a delicate matter of judgement - considered as a major threat to price stability over the medium run, the central bank will act giving more weight to the first pillar and deliberately accept a short term deviation of actual inflation from its objective in order to achieve price stability over the medium run. The policy stance would be like the one advocated by new regime proponents, which is a tightening in the build up phase of a positive bubble and an easing after balances start to unwind in abrupt downward corrections. But to be very clear, such an outcome would still be the optimal policy strategy for a central bank primarily concerned with price stability over the appropriate time horizon. It would not be necessary to target any asset price or pursue a separate financial stability objective, which could commit the central bank with dangerous consequences for the long run stability of the financial system and the economy as a whole.

From this perspective it does not matter whether financial imbalances build up in low or high inflation periods. When the central bank is forward-looking enough, it will set policy rates in order to avoid any inflationary consequences stemming from credit financed asset price booms as well as avoid any deflationary tendencies in times of financial distress.

Before I conclude let me still mention that there is another very recent literature, which suggests that a central bank should immediately respond to asset prices. Some people have argued within the framework of dynamic general equilibrium models that in the presence of nominal rigidities, imperfect competition, and the possibility of non-fundamental asset price movements (affecting capital investment via Tobin's q), the central bank would face a trade­ off between an inflation distortion and an investment distortion. Both have to be optimally balanced, as monetary policy cannot take care of both simultaneously ^[32] . Other results qualify this point arguing that an inflation targeting central bank is well able to contain both distortions ^[33] simultaneously, as long as we face (actual and expected) shocks to productivity growth. Shocks to the net worth of companies instead can again create a trade-off between price stability and optimal investment ^[34] . I have no time to discuss this interesting branch of the literature in more detail. Let me just mention that even if inflation is not the only distortion in the economy I still need to be convinced that the central bank is the best placed institution to deal with the other distortions before I would accept the relevance of these trade­ off findings.

Thus to summarise, while having some doubts that secular victory over inflation can be declared and even more doubts that low inflation tends to cause financial instability, I also fail to see how a central bank following a monetary policy strategy like the ECB would be systematically misled in its policy decisions even in a new regime environment. I do acknowledge that in permanently changing circumstances and especially in transition periods between different regimes, the conduct of monetary policy becomes - in practice - particularly challenging. The importance of a robust strategy cannot be overestimated. As I have tried to explain, the ECB attempts to live up to these challenges.

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