Is monetary policy blind man's buff?

For over a year now, and certainly for the last 10 months, a lot of people have been hyperventilating about what is going on in the financial markets, and what central banks ought to do about it all.

The Bank of International Settlements, amongst its other duties, is supposed to conduct research into such mysteries. It has recently published a paper* on the subject of what happens when asset prices start behaving like rockets.

Maria Socorro Gochoco-Bautista of its Monetary and Economic Department asks the following question: "Do housing and equity booms significantly raise the probability of extremely bad outcomes at the margin?" And the answer is, you guessed it, they do.

The author examined eight East Asian countries and has come up with uniformly bad news. "Asset price booms in housing and equity markets, either separately or jointly but especially in housing, significantly raise the probability at the margin" of a loud pop at some point. It also turns out that:

"The real output gap will be in the left tail of its distribution, in which output is significantly below trend."

"The price-level gap will be in the right tail of its distribution, in which the price level is significantly above trend."

Taken together, and expressed in plain English, the two findings above mean that after a point, as output slows at a faster rate then the rate at which prices are going up, things will get progressively worse in terms of risk.

Eventually, this will lead to a bust. If the tail is unusually fat, as it seems to be now, the bang will be very loud.

A fat tail, by the way, is just that: it is the tail of a probability distribution and means that the fatter the tail or ends are, the more things fall there (for example, 20 per cent of the people write 80 per cent of sense in economics).

In finance a fat tail is something you avoid like a plague because it implies greater risk.

Even worse, say the authors, "the risk of the occurrence of these particular tail events due to asset price booms is largely asymmetric and does not apply to the tails of good outcomes." In plain English that means when things go wrong, they go badly wrong and keep on going wrong.

So how should monetary policy respond? "One implication. is that an approach that is ex-ante more compatible with risk management may be appropriate."

In other words, central banks have to anticipate events and not wait for them to happen. The question to ask in the Indian context is whether the RBI has been doing this or not.

How well or badly they do this depends to a large extent on whether the economy is small or large. In smaller economies, it seems, central bank interventions don't work very well for a variety of reasons.

Thus, ".allowing domestic currency appreciation to slow capital inflows and prevent asset bubbles from forming is no less a blunt instrument for small, open economies than the interest rate is for developed countries. Hence, while allowing more flexibility in the exchange rate is an option, it is not the only one."

So, is India a large economy or a small one?

The other major conclusion is that "in the end, price stability does not seem to be enough." This is something to which the RBI needs to pay heed. Why? "A low, stable inflation environment has not simultaneously brought about financial stability and a more stable asset price environment."

That leaves the monetary policy conundrum unsolved. "While a loose monetary policy may not be the reason for asset booms in east Asia today, large capital inflows might be."

My takeaway from this discussion is this: the whole thing is a blind man's buff and anyone who claims to have the unique solution needs to have his head examined.

*Asset prices and monetary policy: Booms and fat tails in East Asia BIS Working Paper No 243, January 2008. Available at www.bis.org