3.1 The fundamental idea of monetarism

The basic idea of monetarism is the quantity theory of money. The specific form of that theory is often represented by the equationFootnote ² proposed by Fisher: MV = PT (the quantity of money times its velocity of circulation is equal to the price level times the volume of transactions). The identity provides a focus for analysis. It is the relationships between the elements of the identity that are important and which open up legitimate avenues of dispute between economists.

Monetarists would tend to argue that, in normal circumstances, the velocity of money changes in a predictable way. Therefore, an exogenous increase in the quantity of money would lead to an increase in PT. Most monetarists would also argue that, in the long run at least, a rise in the quantity of money would be reflected in a rise in the price level and not in a rise in real national income. From these two propositions comes the conventional monetarist belief that control of the money supply is essential for controlling inflation. There is an excellent discussion of the monetarist exposition of this and the anti-monetarist counter-perspective in two articles in the journal World Economics – Congdon (Reference Congdon2004) and Mayer and Minford (Reference Mayer and Minford2004).

3.2 Key propositions of monetarism

The presidential address of Milton Friedman to the American Economic Association (Friedman, Reference Friedman1968) and a Wincott Lecture in the UK (published as Freidman, 1970) provided important turning points in the intellectual debate between monetarists and their opponents. Naturally, the academic debate was beginning to develop a few years before, but these events and subsequent publications influenced a wider communityFootnote ³. Once again, formal monetary theory began to take as a starting point the proposition that nominal national income (P*T) would be affected by changes in the supply of money rather than those changes being offset by a change in the velocity of circulation. In his exposition of the main monetarist propositions, Friedman (Reference Friedman1970) also anticipated important future theoretical issues that would arise in the following few decades. It is worth restating these because they are highly relevant for a discussion of the relationship between monetary policy and financial markets. The points are also noteworthy because they demonstrate an underlying pragmatism in Friedman's ideas that eventually led to Keynesians, neo-classical economists and monetarists debating the extent and timing of the various forces identified by Friedman rather than whether these forces existed at all.

Specifically, Friedman identified the followingFootnote ⁴:

1. 1. There is a consistent, though not precise, relationship between the rate of growth of the quantity of money and the rate of growth of nominal national income.

2. 2. There are long and variable lags in this relationship.

3. 3. The change in the rate of growth of nominal income arising from a change in monetary growth typically shows up first in output and hardly at all in prices. There will be upward pressure on prices only as a gap emerges between actual and potential output.

4. 4. Even after allowance for the delay in the effect of monetary growth, the relationship between monetary growth and prices is far from perfect.

5. 5. Inflation is always and everywhere a monetary phenomenon in the sense that it is produced only by a more rapid increase in the quantity of money than in output.

6. 6. The initial effect of a change in the quantity of money is not on income but on the prices of existing financial and physical assets.

7. 7. A change in monetary growth affects interest rates in one direction at first but in the opposite direction later on. Monetary growth tends to lower interest rates at first and then raises interest rates as a result of the effect of changes in actual or expected inflation.

These points and qualifications are important for a number of reasons. They provide the basis for debate between monetarist, Keynesian and neo-classical schools. Secondly, they indicate that changes in monetary policy are “transmitted” through the economy: this transmission mechanism – is a key issue in understanding the relationship between monetary policy and financial markets. Point 6 is clearly important in this regard. Thirdly, the propositions highlight the crucial role of expectations – something that is especially important in thinking about the way in which monetary policy changes affect financial markets. Finally, the link between monetary growth and interest rates is highlighted: clearly, this is also important for understanding the relationship between monetary policy and financial markets – especially as the effect on interest rates may not be the same in the short-term and in the long-term.

A more recent statement of the monetarist position appears in McCallum and Nelson (Reference McCallum and Nelson2010, page 11). They state: “An exogenous change (if it somehow occurred) in the rate of growth of the money stock would, therefore, induce a change of the same magnitude in the inflation rate unless it induced a change in the rate of growth of real transactions or the real interest differential. Neither of these possibilities seems at all likely, so the QTM [quantity theory of money] essentially implies that steady-state inflation rates move one-for-one with steady-state money growth rates.” McCallum and Nelson (Reference McCallum and Nelson2010 e.g. page 29) report strong relationships between money growth and inflation in the long run. The key point, however, is not that there is a perfect, one-for-one relationship between money and inflation: the velocity of money may drift up or down over time for various reasons and changes in regulation and technology may lead to one-off changes in the velocity of money. However, the monetarist position argues that an exogenous shock to money growth will lead – in the long run – to a related change in inflation. The change in money supply will not, itself, lead to a change in velocity of circulation or real national income.

4.1 Non-bank financial institutions and the transmission mechanism

Given that they are the focus of actuarial professional life, it is worthwhile considering the effects of changes in monetary policy on non-bank financial institutions in greater depth.

Financial markets could be an important conduit through which changes in monetary policy are transmitted to the wider economy. It is therefore worth noting the contributions of Congdon who has specifically outlined the distinct role of non-bank financial institutions (insurance companies, pension funds, mutual funds and so on) in this process. Congdon (Reference Congdon2005) looks empirically at the relationship between non-bank money holdings, asset prices and the wider economy. He regards non-bank financial institutions as key to this process. As they invest mainly in securities markets and are the main institutions in which there is an actuarial interest, these ideas are obviously relevant to this paper.

If money holdings of non-bank financial institutions rise, they will, Congdon argues in an extension of the work of the early monetarists, spend that money on financial assets. Keynes understood the potential for such links but his focus was on a much narrower range of assets. This link between money and financial assets can take effect for two reasons. Firstly, as was mentioned above, moneyFootnote ⁸ yields no return and thus institutions do not want to hold more than is dictated by considerations of liquidity requirements and risk. Secondly, many institutions operate with investment guidelines that will discourage them from increasing the amount of money held. The excess money balances will be spent in securities and real estate markets and this could create, if monetary policy is very loose, an “asset price boom.” As far as bond markets are concerned, this will manifest itself in lower nominal and real long-term interest rates as well as reduced credit spreads. At the same time, there may well be lower short-term interest rates if changes in monetary policy are signalled via short-term interest rates.

It may be thought that this hypothesis, if true, undermines the efficient market hypothesis though it does not undermine the idea that securities are priced efficiently relative to one anotherFootnote ⁹. Indeed, Pepper (Reference Pepper1994) argues that the influence of money on asset prices requires a qualification of the efficient market hypothesis. The correct way to explain this phenomenon would be as follows: the efficient market hypothesis is a theory of asset values in equilibrium; a monetary bubble involves a disturbance of that equilibrium; this disturbance is then transmitted through securities markets; eventually equilibrium will be restored at a higher price level in both asset markets and the real economy. As Meltzer (Reference Meltzer1995, page 50) puts it: “[B]efore impulses are fully absorbed, relative prices and real output respond to monetary impulses…time is required to distinguish between permanent and transitory impulses and real and nominal impulses.”

Asset prices are, of course, just one channel of transmission. Congdon argues that it is an important channel that is too often ignored. The Austrian theory, discussed below, very much emphasises this mechanism too and specifically emphasises the way in which the transmission of monetary policy through asset markets distorts the real economy. Congdon produces convincing evidence of the impact of non-bank financial institution money holdings in creating asset price booms (and busts). Specifically this includes the boom before the US Great Depression, that before the Japanese malaise and a number of UK episodes. The key relationship, for the UK, is estimated as followsFootnote ¹⁰:

Change in composite investment price index Footnote ¹¹% per annum = 2.97 + 0.42(change in non-household money)% per annum + e_t

R squared = 0.42

Standard error of regression coefficient = 0.06

t statistic for regression coefficient = 7.24

By Congdon's own admission, he did not use the most sophisticated econometric techniques. But there is strong evidence – as well as strong theory – that there is a process here that should not be ignored by institutional investors. Congdon (Reference Congdon2007) points out (see, especially chapters 14 and 15) that there has been a huge expansion of non-bank financial sector balance sheets in the last 40 years but very little change in the ratio of cash held to total assets a ratio which, as many actuaries would recognise, is generally determined by factors such a liability and liquidity requirements. As such, non-banks do not have an infinitely elastic demand for money.

Asset prices are, of course, only the first part of the transmission mechanism (see Congdon, Reference Congdon2007, chapter 14). A monetary-induced rise in asset prices can affect the real economy in various ways (for example, it can lead to more share issues as the relationship between share values and the replacement cost of capital changes; lead to mortgage equity withdrawal and lead to more residential and commercial real estate building as the relationship between house values and land values change). Again, there are strong similarities here between the position taken by broad-money monetarists such as Congdon who emphasise the transmission mechanism and the Austrian school discussed below. However, their methodological approach is so different that neither school is keen to recognise those similarities.

It is important to point out that there is an important distinction between money and credit in this analysis. An increase in credit can be financed in various ways that do not involve an increase in the supply of money.Footnote ¹² An important paper by Borio et al. (Reference Borio, Kennedy and Prowse1994) shows that monetary policy was an important determinant of asset prices in the 1970s but, in the 1980s, expansions in credit were more important. Such credit expansions often came about as a result of liberalisation of credit markets which would make it easier for individuals to borrow in order to invest in real assets. Both monetary and credit expansions can take place through the banking system and can therefore be confused with each other.

Congdon's work highlights the role of non-bank financial institutions in the transmission mechanism. There are other potential channels of monetary policy that can affect asset prices. For example, Benanke and Blinder (Reference Benanke and Blinder1992, section IV) suggest that transmission channels through the banking system to asset markets can be important. A tightening of monetary policy could lead to a shortage of liquid funds within banks and this shortage of liquid funds, in the short term, cannot be rectified by reducing bank lending. Instead the shortage will be rectified by the banks selling securities. The opposite process will occur if there is a loosening of monetary policy. This is still important for non-bank financial institutions as it suggests that security prices could deviate from fundamental value during the process of transmission of monetary policy changes.

4.2 Money balances and asset prices – the work of Gordon Pepper

Actuary Gordon Pepper studied relationships between investment markets and monetary aggregates as an investment practitioner. In particular, he used money supply measures extensively in his analysis of the behaviour of bond markets. The ideas have been published in Pepper (Reference Pepper1994), Pepper with Oliver (Reference Pepper and Oliver2006a) and Pepper with Oliver (Reference Pepper and Oliver2006b). Earlier work included two Institute of Actuaries’ Sessional Meeting papers (Pepper, Reference Pepper1970 and Pepper and Thomas, Reference Pepper and Thomas1973) with the former paper dealing mainly with the institutional background.

Pepper and Thomas (Reference Pepper and Thomas1973) considers the issue from the perspectives of practical investors observing how and when transactions take place and how and when expectations are formed. However, a formal theory of the transmission mechanism is consistent with the authors’ observations. The authors argue (Part II) that increases in the money supply lead either to the spending of excess balances on financial assets and therefore lead to lower gilt yields and – with a longer lag – to increases in equity values. The decrease in gilt yields would be reversed in the medium term as expectations of inflation roseFootnote ¹³.

The authors also suggested that, if increased money balances were spent by individuals or firms on goods and services, rather than by non-bank financial institutions on securities, the initial financial impact of a loosening of monetary policy would be on the equity market. This would be because economic activity would rise before inflation rose, causing both the money and real level of profits and dividends to rise in the short term. The impact on the gilt market would be delayed in this case because the transmission mechanism would not involve financial assets; the only effect on gilts would be a rise in yields because of a rise in inflation expectations.

If the transmission mechanism involves individuals spending increased money balances on goods and services, rather than on financial assets, then the impact on real variables in financial markets is relatively small. Financial markets would merely be reacting to temporary changes in the real economy caused by a change in the money supply. As has been mentioned already, Meltzer (Reference Meltzer1995) suggested that the transmission mechanism was likely to be through financial markets initially because of the lower transactions costs in financial markets as compared with the real economy.

Pepper's theories concerning the influence of monetary policy on financial markets were refined in later work. Pepper with Oliver (Reference Pepper and Oliver2006a), Pepper with Oliver (Reference Pepper and Oliver2006b) and Pepper (Reference Pepper1994) looked at the evidence in much more detail. The key empirical question is whether changes in monetary policy have significant effects on asset markets as a result of the way in which those changes are transmitted through to the economy. Their findings can be summarised as follows:

The authors recommend that monetary aggregates are monitored and interpreted for the purposes of investment analysis. Interestingly, there is no contradiction here between Pepper's findings and those of the Austrian school (discussed below) or the mainstream monetarist school, though Pepper approaches the subject from a practitioners’ perspective rather than from that of a theoretician. Indeed, the transmission mechanism proposed by the Bank of England (see below) contains elements of the thinking outlined by Pepper. Pepper's theory is less formal but more rooted in the practice of investment analysis. Furthermore, the details of Pepper's work – including, for example, the study of the impact of different definitions of the money supply – is detailed and precise.

The analysis of Pepper and Thomas also came with prescient caveats. These anticipated later developments in theory. For example, they suggested that their analysis might become invalid if the Bank of England attempted to control the money supply – which it did not do so until after their papers were writtenFootnote ¹⁴. Secondly, the authors argued that, when the relationships became widely known, they may change.

5.1 New-Keynesian models

The basic new-Keynesian approach to monetary policy models three relationships. Firstly, output today (y) is a function of expected output in the next period and the expected real interest rate j (based on the current nominal interest rate (i) and the expected rate of inflation (r)):

$$ {{y}_t}\, = \,f(E({{y}_{t\, + \,1}}),\,{}{{j}_{t,t\, + \,1}})\,\,and\,{{j}_{t,t\, + \,1}}\, = \,{{i}_t}\,{\rm{ - }}\,{{E}_t}({{r}_{t\, + \,1}}) $$

The second relationship assumes that firms are oligopolistic and that prices adjust slowly in the real economy if there is a change in monetary policy (if all prices changed instantaneously, there would be few real effects from a change in monetary policy). Thirdly, it is assumed that interest rates are determined using a Taylor Rule whereby short-term interest rates are set according to deviations of inflation and output from implicit or explicit target rates so that:

$${{i}_t}\, = \,f({{\pi }_t},\,{{y}_t}){\rm{.}}$$

This approach does not completely suppress the asset price channel in terms of the transmission of monetary policy changes. However, the asset price channel is very much implicit. The new-Keynesian model reflects the fact that monetary policy – at least in “normal” times – is conducted by adjusting short-term interest rates rather than by controlling the quantity of money directly. As has been noted by Bernanke, the impact of short-term interest rate changes on asset prices are believed to be minor. It should also be noted that expectations play an important role in modern new-Keynesian models – just as they do in neo-classical modelsFootnote ¹⁶.

Perhaps the most succinct way of summing up the new-Keynesian approach is as follows: “In particular, we wish to make clear that we adopt the Keynesian approach of stressing nominal price rigidities, but at the same time base our analysis on frameworks that incorporate the recent methodological advances in macroeconomic modeling (hence the term “New”)” (Clarida et al., Reference Clarida, Galí and Gertler1999, page 3). Those recent advances include an important role for expectations within the new-Keynesian models.

Because new-Keynesian models assume nominal rigidities in product and labour markets, any change by the central bank to nominal short-term interest rates will give rise, at least temporarily, to a change in real short-term interest rates – prices will not respond instantaneously. However, it is recognised that, should a central bank persistently try to push inflation above target, there will be no gain in output in the long run, though there will be persistent inflation (Clarida et al., Reference Clarida, Galí and Gertler1999, page 17). The neo-classical insights on the importance of monetary policy institutions being “credible” are also incorporated, as new-Keynesians believe that there will be a better short-run inflation versus output trade off if the central bank is credibleFootnote ¹⁷.

As has been noted, the new-Keynesian approach plays down the direct role of money and the transmission mechanism through asset markets and focuses on the real economy. However, some asset market channels are regarded as important by new-Keynesians. These include the relationship between short-term interest rates and long-term interest rates and the subsequent effect on asset prices (see below). Also, a loosening of monetary policy may ease the ability of firms to finance investment (by reducing their interest costs) and encourage banks to lend to firms about which they have less publicly available information (because their interest costs are a lower proportion of cash flows). These could be regarded as “Keynesian” effects because the emphasis is on the way in which a fall in interest rates reduces the costs faced by firms resulting from market imperfections. These so-called “credit channels” are investigated by Ehrmann and Fratzscher (Reference Ehrmann and Fratzscher2004). They find strong evidence that changes in monetary policy affect different types of firms in different ways and, in particular, that those firms that are most financially constrained are affected most by monetary policy. Furthermore, they also find evidence that shares in cyclical companies – that is those firms producing products the demand for which varies the most as economic conditions change – are affected the most by interest rate changes. Again, this would suggest a Keynesian mechanism that ran from the real economy to asset markets rather than the other way round. If monetary policy is loosened, this benefits particular firms and, as such, their share price could increase. This contrasts with – though may work in addition to – the mechanisms suggested by Congdon which work directly via changes in behaviour within financial markets which directly transmit changes in the quantity of money through to the real economy. It is also worth noting that Clarida et al. (Reference Clarida, Galí and Gertler1999, 5.2) mention that sharp, unanticipated interest rate increases might generate financial losses for banks and financial institutions exposed to interest rate risk but this point is not really developed by the authorsFootnote ¹⁸.

These ways in which the financial sector are affected by monetary policy are indirect and largely operate through changes in monetary policy operating in the context of a real economy that is not free of frictions. As it happens, these new-Keynesian mechanisms, to some extent, formalise some of the channels mentioned by Pepper. As far as financial market practitioners are concerned, the key variables to consider would not be measures of broad money held by financial institutions but the different effects that changes in interest rates might have on firms that face different business conditions and financial structures. Essentially, this is only of interest to those actuaries involved in investment analysis rather than in the financial management of non-bank financial institutions.

As noted, asset markets are “bit part” players in Keynesian models. In this context, the observation by Clarida et al. op cit (page 44) is interesting:

As we shall see below, neo-classical economists would also not incorporate such events into their models. However, in their case, they would be less inclined to demand policy action – based on either instinct or theory.

5.2 The neo-classical school and the sidelining of asset markets

As with the new-Keynesian school, the neo-classical school has relatively little to say about the impact of monetary policy on asset prices and financial markets more generally. Neo-classical thinking emphasises the speed with which changes of policy can be transmitted through the economy, particularly if they are anticipated.

Goodfriend (Reference Goodfriend2002) summarises the neo-classical model as follows – though different notation is used here. Household consumption in the current period (c₁) and in the future period (c₂) is determined by the market real rate of interest (r) and the consumer's time preference (ρ) as shown by the equation:

$$({\rm{1}}\, + \,r)\, = \,(1\, + \,\rho ){{c}_1}/{{c}_2}$$

Similarly, labour supply is determined by the household's time constraint, real wages and the preference for work and leisure. Equilibrium output, y* is determined by production technology which determines labour productivity (a) and the profit maximising mark-up (μ*):

$${{Y}^\ast} \, = a\,\frac{1}{{1\, + \,{{\mu }^\ast} }}$$

The real rate of interest in this model equilibrates household consumption plans and companies’ investment plans. If productivity is expected to rise, for example, households may wish to borrow more and spend more today in order to smooth their real consumption patterns in anticipation of rising real incomes. This raises the real rate of interest so that consumption plans match the expected growth in productivity. The equilibration will also be facilitated by investment plans being reduced as the real rate of interest rises (as a second-order effect) and therefore the growth in productivity slowing.

This model can be used to explain at least part of the consumption boom and low savings rates in both the UK and the US in the lead up to the financial crash of 2008. In both the UK and the US, it was widely believed that productivity growth had increased. This was reflected in the UK government raising its estimate of the sustainable growth rate in the late 1990s. In the US, it was widely believed that improvements in technology had raised productivity growth. The neo-classical model would suggest that individuals would raise consumption and this would put upward pressure on real interest rates in a closed economy. However, the openness of the UK and US economies adds an extra aspect to the process. Capital inflows from countries with high net savings to countries where higher consumption is putting upward pressure on interest rates can keep equilibrium interest rates low and current consumption high in countries where there would otherwise be upward pressure on interest rates.

Whatever the processes in this model, however, it is real factors and not changes in monetary policy that are at the root of rapid movements in asset prices. As Selody and Wilkins (Reference Selody and Wilkins2004, page 4) put it:

Followers of these schools therefore look for non-monetary explanations of causes of rapid asset price movements. These can include real factors such as changes in the productivity of capitalFootnote ¹⁹ and a small class of self-fulfilling speculative bubbles. Also, increases in world saving will, if capital markets are free, increase asset prices throughout the world – thus, it would be argued, the increase in savings in Asia could have been a real factor in raising asset prices in the early twenty-first century, though they would not have caused the financial crisis in the neo-classical model. Such models of the economy and the role of interest rates in these models do not allow for the possibility that monetary policy will be the cause of substantial investment market disequilibria.

5.3 Neo-classical/new-Keynesian synthesis

The neo-classical and new-Keynesian models have been “synthesised” into models that today form the basis of much thinking within central banks. Both schools, and by implication the synthesis, play down the roles of the quantity of money and the financial sector in the operation of monetary policy. On the other hand, the quantity of money and the financial sector are regarded as crucial in the monetarist and Austrian schools as they were by Keynes himself. For the neo-classical school, changes in monetary policy have no impact on real variables if changes in monetary policy are anticipated – this would include effects on asset markets. In the new-Keynesian school, as Congdon argues (Congdon, Reference Congdon2007, page 13): “In line with their theoretical commitments, they instead advocate that the central bank rate should be set by ‘looking at everything’, although with particular focus on the output gap.” This explains the wide-ranging econometric models used by central banks with only a little emphasis on money itself. More precisely, Congdon could have said that new-Keynesians look at everything but money and asset prices. The focus is very much on the transmission mechanism of money through the real economy, though “credit channels” may also be considered important channels of transmission in some new-Keynesian models.

In the synthesis, many broad principles of the neo-classical school are accepted but stickiness in labour and product markets is assumed so that real variables may respond to a monetary policy shock in the short term. Expectations are crucial in this synthesis and the credibility of the central bank is important in forming expectations. Although this is not the main theme of the article, it is worth developing this point further because it has some relevance for financial markets.

If a central bank has a very strong degree of credibility, so that economic agents believe that it will hit its inflation target, its actions will be anticipated by investment markets. For example, if the inflation target is 2%, then the difference between real interest rates on index-linked bonds and nominal interest rates on conventional gilts is likely to be very close to 2% if the central bank is credibleFootnote ²⁰. If there is a need for the central bank to change interest rates to hit the target, the market will anticipate that change and will reflect future changes in interest rates in the yield curve. The central bank will then behave in a smooth and predictable way and the markets will partly do the central bank's job for it as interest rates rise in the markets to reflect the anticipation that the central bank will act. It is tempting to assume that, once credibility has been achieved, the central bank does not have to do any further workFootnote ²¹. This is not the case. If the central bank does not react to real shocks where necessary, by changing interest rates, then the inflation target will no longer be hit. However, when the central bank does react there will be much less “noise” – inflation expectations in financial markets should still be close to the target and central bank and market interest rates should be close to each other.

Information about the credibility of the inflation regime can be obtained from asset markets as well as from surveys and from wage movements in labour marketsFootnote ²². Increasingly it is felt that the credibility of central banks is enhanced by making them operationally independent of government and giving them no incentive to raise employment and output in the short run by loosening monetary policy.

Thus, in these models the role of asset markets in communicating monetary shocks is downplayed. Asset markets reflect consistent expectations that the central bank will hit its inflation target. Asset markets can, however, provide important information about inflation expectations and about the credibility of the central bank in achieving its monetary policy objectives but they are not regarded as important in the transmission of changes in monetary policy through the economy.

8.1 Austrian monetary theory in outline

Those aspects of Austrian monetary theory that relate monetary policy to financial markets are stated in von Mises (Reference Von Mises1981)Footnote ³⁰. The basic idea is that an expansion of credit by the central bank, achieved by holding interest rates below the level that would prevail as a result of the interplay of supply and demand in the market for savings and investment funds, will lead business people to borrow and invest in more capital-intensive production processes. Modern variants of the theory would also emphasise how holding interest rates low would lead households to spend more on goods that have an investment characteristic such as housing and consumer durablesFootnote ³¹. Von Mises (Reference Von Mises1981, chapter 19, part 4) explains as follows: “Now if the rate of interest on loans is artificially reduced below the natural rate as established by the free play of the forces operating in the market, then entrepreneurs are enabled and obliged to enter upon longer processes of production.” These theories were then developed with a greater degree of rigour and formalism by Hayek (Reference Hayek1931) and Hayek (Reference Hayek1941).

Inappropriate monetary policy involves the distortion of a price – the rate of interest – which should coordinate the supply of and demand for savings and funds for investment. In the absence of central bank manipulation, interest rates would rise, for example, if there were an increase in demand for funds for investment – as a rise in interest rates would be necessary to draw more savings into the market and to discourage marginal borrowersFootnote ³². If interest rates are held below this equilibrium level by the central bank, there will be an expansion of the money supply and, encouraged by low interest rates, consumers and businesses will spend more on consumer durables and investment projects. This process would explain how “property booms” are often associated with “monetary booms”.

So far, there are similarities between these processes and aspects of the monetarist transmission process. However, for our purposes, there are two important differences between the monetarist and Austrian schools. Firstly, in the period of monetary expansion, the distortion of investment and consumption decisions by interest rates that are too low is the key problem: for monetarists, the possibility that the transmission mechanism might give rise to such distortions is secondary to other considerations. Secondly, Austrians would argue that a recession must follow a monetary boom. This is because the investment projects that have been started in the boom (property building, investment in more capital-intensive production methods, the purchase of consumer durables and so on) either cannot be completed or must be reversed: resources have been misallocated as a result of interest rates being held down and, eventually, this misallocation has to be reversed. This reversal is the process of recession. Thus, whilst both neo-classical economists and monetarists may believe that recession can be more-or-less avoided, even after monetary policy mistakes that have led to a boom, as long as appropriate policies are followed, Austrian economists would not accept this. For Austrians, there is an inevitable contraction after the boom.

As has been noted, and as is clear from the neo-classical model, an increase in saving can also cause a fall in interest rates, a rise in stock market values and a rise in real investment: interest rates are not only affected by monetary policy. However, de Soto would argue (see de Soto Reference De Soto2006, page 459–466) that an increase in genuine saving will generally be insufficiently rapid to cause a stock market to rise rapidly in a bubble-like fashion. There may be a once-and-for-all increase due to real factors but not a continuing boom. On the other hand, a rise in the money supply, which leads to an increase in asset prices can be as rapid as the central bank permitsFootnote ³³.

There are several mechanisms by which the rise in money supply can feed into stock market values according to Austrian thinking. Firstly, interest rates fall relative to the level that would be determined by the interaction of savings and funds demanded for investment. Whilst this generally only applies to short-term interest rates, a fall in short-term interest rates can have many indirect effects on the value of a company, not least because it reduces debt servicing costs: this mechanism is no different from those described above. Furthermore, any prospective rise in the general price level may not only raise the nominal value of a firm's investment projects but also reduce the real value of its debt. The fall in interest rates also encourages more capital-intensive methods of production and this raises the value of capital goods generally (the most visible example being the rise in property values and rents). This, in turn, raises the prices of securities which represent claims on the returns generated by capital goods. Rising stock market values provide collateral for further bank credit which can be used to extend leverage and invest further in the stock market. A continual supply of funds provided by the banking system is necessary to fuel the corresponding stock market boom (see de Soto, Reference De Soto2006 pages 459–466).

Many actuaries, especially those steeped in modern financial economics, would be uncomfortable with the lack of mathematical formalism in the Austrian approach. In response, proponents of Austrian theories would argue that the language of mathematics is too precise to articulate the tendencies and subtleties that economic processes involve. We can say that there is a tendency for stock market prices to rise if savings rise or if monetary policy is loose but exactly how this will manifest itself will depend on the inter-dependent actions of millions of people investing trillions of pounds, all reacting subjectively to the very particular information that they can access whilst many other variables are changing simultaneously. Thus we can explain these tendencies, or produce “pattern predictions” using data to help understand the tendencies better, but we cannot model them with the precision that would satisfy a neo-classical economist. In practice, though, monetary booms in different economic conditions can have apparently unique specific effects, whilst being particular examples of a general phenomenon. This is, perhaps, a testament to the validity of this approach.

There are several lessons from the Austrian school that are important for those working in investment markets. The main ones are as follows:

• • Stock market prices will be affected by the volume of saving in an economy or by changes in expectations about productivity.

• • However, such real variables are likely to change slowly over time and thus are unlikely to give rise to a rapid rise in market values.

• • A rapid rise in stock market prices is likely to be associated with a monetary boom. A rapid rise in stock market values caused by a monetary boom will eventually be reversed but could continue as long as the expansionary monetary policy continues.

• • To the casual observer in normal conditions, it may be difficult to distinguish between a rise in the market caused by real factors and a rise caused by monetary factors – unless the rise is very rapid. However an analysis of economic data should reveal the underlying causes, even if precise predictions cannot be made and models built.

8.2 Austrian theory and efficient markets

Actuaries and financial economists may object to these lines of reasoning on the grounds that they violate the efficient markets hypothesis and rational expectations. If market actors can see that a monetary boom is causing a rise in asset prices and that the boom will eventually come to a halt and reverse, then why do fund managers not simply ignore the monetary boom and refuse to invest in the rising stock market? The Austrian response to this is that market participants are not perfectly informed. They are responding to particular information sets that they believe are relevant to their situation. Lower interest rates, rising company profitability, reduced risk premiums because of the perceived rise in the value of collateral that is backing lending and so on, all make it very difficult for private sector actors (entrepreneurs, company managers and fund managers) to distinguish between real factors that affect the stock market and monetary factors. The longer the boom goes on and the greater the extent to which real and monetary factors point in the same directionFootnote ³⁴ the more difficult it is to distinguish between real and monetary factors: there is a large amount of “noise” amongst the information that investors need to use in order to make sound, long-term investment decisionsFootnote ³⁵. This difficultly of distinguishing between the real and monetary causes of price signals that entrepreneurs are receiving is indicated by the description of the late 1980s Swedish property bubble in Dillen and Sellin (Reference Dillen and Sellin2003, pages 132–133). The possible causes identified include high inflation, tax relief, rising incomes and credit market deregulation, as well as loose monetary policy.

9.1 Anti-”bubble-pricking”

On the whole, adherents to the neo-classical view would argue that an environment of low and stable inflation is conducive to avoiding financial bubbles and that price stability should be the target of the central bank. As it happens, though, two major stock-market booms (those of 1923–1929 and 1994–2000) occurred during periods when consumer price inflation was relatively low – and the recent financial crash also occurred during an environment of low consumer price inflation. Bordo and Wheelock (Reference Bordo and Wheelock2004) argue that whilst there is no consistent relationship between inflation and stock market booms, such booms ‘have typically occurred when money and credit growth were above average’ (page 19, my italics)Footnote ³⁶. Asset price booms are also, according to Bordo and Wheelock, strongly associated with strong real growth and advances in productivity.

In the neo-classical paradigm, the relationship between asset prices and strong growth in the real economy is especially important. Strong real economic growth, driven by increases in productivity, can lead to (or be driven by) higher returns on capital. This increases returns to equity and has obvious implications for future dividend growth and equity valuations. This hypothesis is perhaps best expressed in the work of Fama who concludes (Fama, Reference Fama1981, pages 563–564): “Stock returns are determined by forecasts of more relevant real variables and negative stock return-inflation relations are inducted by negative relations between inflation and real activity…[E]xpected real returns are determined in the real sector”.

In practice, even if some link between monetary policy and asset prices is accepted, it can be difficult to distinguish between real, monetary and speculative contributions to an asset price bubble. The neo-classical models in particular see little room for the analysis of asset prices in the determination of monetary policyFootnote ³⁷. Using monetary policy to ‘burst’ a bubble that is caused by real factors can have significant dangers for the real economy – leading to recession and deflation (see Goodfriend, Reference Goodfriend2002 pages 186–187).

Following this reasoning, the orthodox central banking view is sceptical of the “bubble pricking” approach. Bernanke's views on this are well known and have been expressed in Bernanke and Gertler (Reference Bernanke and Gertler2000 pages 3–4)Footnote ³⁸:

Bean (Reference Bean2003) made a very similar argument. The inflation target is sufficient in Bean's view and it does not preclude policymakers from taking asset price developments into account in their models.

Furthermore, as has been noted above, increases in asset prices can take place as a result of an increase in the supply of credit rather than in the supply of money (Borio et al., Reference Borio, Kennedy and Prowse1994). Such asset price “booms” can be rational if the liberalisation of credit has made behaviour possible that was previously restricted. Nevertheless, Borio et al. do suggest that asset markets can provide some information about future inflation and thus asset price information might be useful when setting monetary policy – though they reject the use of hard and fast rules. In later work (Borio and White, Reference Borio and White2004, page 33), it is suggested that:

Goodhart and Hofmann (Reference Goodhart and Hofmann2003) use a vector auto-regressive model to examine the effect of monetary policy and credit growth on asset prices. They do not deny the basic monetarist position regarding the importance of monetary policy for asset prices. However, they conclude (page 10):

The authors also stress the potentially catastrophic effects of a decision to “burst” an “asset bubble” being mistimed, citing the examples of both the Great Depression and the Japanese malaise. Even if the asset price channel for the transmission of monetary policy is accepted it does not follow that the targeting of asset prices by monetary policy markers is appropriate.

9.2 Asset price information in the monetary policy framework

A situation whereby there is an increase in asset prices associated with loose monetary policy whilst, at the same time, increases in consumer prices remain low, is most consistent with monetarist and Austrian theories. According to these theories, as explained above, loose monetary policy has a tendency to feed into asset prices via its impact on real interest rates before it feeds into general inflation. The more the central bank is able to credibly commit to low consumer price inflation, the more any impact of loose monetary policy on consumer prices will be delayed with the impact on asset prices being the main manifestation.

According to both the monetarist and Austrian views, high asset prices can be a ‘signal’ of loose monetary policy – that is they provide information to monetary policy makers in the same way that currency movements might provide information about loose monetary policy in an international monetarist model. Monetarists such as Congdon, who emphasise the role of asset markets in the transmission mechanism, would also associate their ideas with post-Keynesian theories whereby an increase in money leads to a substitution of money for liquid assets (for example short-dated bonds) and then a series of portfolio rebalances that leads to an increase in the prices of less liquid assets (see Tobin, Reference Tobin1969 and Brunner and Meltzer, Reference Brunner and Meltzer1973).

However, even according to the Austrian and monetarist views of monetary policy, asset price targeting by a central bank would not be an appropriate policy objective. Once an asset price bubble has built up due to loose monetary policy, there is nothing that can be done to alleviate the problems loose monetary policy has caused. Action needs to be taken to set monetary policy back on a sustainable course. Asset price booms are merely consequential in nature resulting from the previously lax monetary policy.

As has been noted, the Bank of England has tended to take an eclectic approach to monetary policy with a macro-model that does not model money supply measures directly but one that uses a broad range of economic variables. As has also been discussed above, the Bank regards asset prices as an aspect of the transmission mechanism and thus asset price movements might provide information about how loose monetary policy is. Movements in certain asset prices (particularly index-linked and conventional gilt yields) also provide the Bank with information about the market's confidence that the inflation target retains credibility. This information has been used by the Bank of England and commented on publicly since the second quarterly inflation report in May 1993.

Alchian and Klein (Reference Alchian and Klein1973) approach this subject from a slightly different perspective. They argue that asset prices should be taken directly into account in setting monetary policy goals. Alchian and Klein point out that, given that asset prices are the price of future consumption, they should be taken into account along with the price of present consumption (and given an appropriate weighting) when setting monetary policy. Specifically, according to Alchian and Klein, the utility that a household obtains from consumption is:

$$U\, = \,U\{ [q(i,t)]\} $$

Where q(i,t) represents the quantity of the ith consumption service flow at time t. Alchian and Klein also cite the transmission process suggested by many monetarists and which is explicit in Austrian theory. When monetary policy is loosened, this disturbs the term structure of interest rates and, as such, raises asset prices and the price of future consumption before it has an impact on general consumer prices. Incorporating asset prices in the price index would therefore have the incidental advantage of leading the central bank to react to inflationary pressures earlier as well as fundamentally taking a more comprehensive view of inflation. As has been widely noted, even the current user cost of housing was explicitly excluded from the price index targeted by the Bank of England from 2003. If the targeted index excludes those items that respond most rapidly to monetary stimuli then monetary policy responses will be delayed. Perhaps the most obvious application of the Alchian and Klein suggestion – the wider application of which is fraught with practical difficulties as the authors admitFootnote ³⁹ – is that increases in house prices should be incorporated in prices indices targeted by central banks. This should lead to the taming of asset price booms at an earlier stage in their development.

Thus, two distinct reasons for taking asset prices into account when setting monetary policy have been identified here. Asset prices might lead monetary policy makers to anticipate increases in consumer prices which were preceded by increases in asset prices. Secondly, it can be argued that monetary policymakers should, as a matter of principle, take a wider view of inflation that takes into account the price of future consumption. However, in neither case are authors arguing that central banks should try to prick irrational asset price bubbles because such bubbles are harmful in themselves.

9.3 “Leaning against the wind” and “bubble pricking”

Other authors, such as Wadhwani and Cecchetti would go further and suggest that monetary policy should explicitly take into account developments in asset markets even if those developments are not caused by loose monetary policy. This is often described as “leaning against the wind”. There is a particularly good discussion of this approach in Wadhwani (Reference Wadhwani2008) and in Cecchetti et al. (Reference Cecchetti, Genberg and Wadhwani2002).

The argument is essentially made in a neo-classical/new-Keynesian framework. Wadhwani suggests that, if inflation is forecasted in an output gap model (that relies on modelling the difference between actual and potential output), this essentially ignores the role that asset prices play in the real economy. Asset bubbles, according to Wadhwani, raise consumption and investment and, importantly, can arise exogenously. In developing appropriate policy responses, we can distinguish between three situations. If asset prices rise due to a productivity shock the central bank should not react as asset prices are simply reflecting fundamentals, argues Wadhwani. If asset prices rise due to loose monetary policy, then the central bank should react but Wadhwani's view does not add anything to the approaches suggested by monetarists and others as explained in 9.2. However, if a bubble arises simply because of the behaviour of investment-market participants but is not driven by fundamentals then the central bank should take this into account when setting monetary policy. Given that asset-price bubbles raise consumption and investment, the argument proceeds that, if a Taylor rule were being followed whereby interest rates depend on inflation relative to a target and output relative to potential, this should be adjusted if there is a bubble.

The proponents of leaning against the wind argue that their proposal simply adds an extra element into the models that are used to forecast inflation and, in particular, that this element is especially important in understanding the evolution of inflation over long-term time horizons. The contrary argument is that the central bank cannot distinguish between investment market fluctuations caused by (for example) a change in productivity and those caused by other factors. The proponents of leaning against the wind counter that, if the central bank is controlling monetary policy, it has to make judgements about many matters in economic models – including developments in the non-financial part of the real economy (see Cecchetti et al., Reference Cecchetti, Genberg and Wadhwani2002 in particular). As such, making judgements about the causes of a bubble is no different. The Austrian and monetarist response to the leaning against the wind approach would be that prolonged bubbles tend to be caused by mistaken monetary policy which should, indeed, be corrected. It would then be cautioned that going further and reacting to bubbles that are not caused by loose monetary policy but by herding and speculative behaviour in financial markets is simply likely to lead to further policy mistakesFootnote ⁴⁰.

Roubini (Reference Roubini2006) goes further and argues that, if monetary policy can affect asset prices then, given the serious problems that arise when bubbles burst, central banks ought to anticipate their bursting. Monetary policy should therefore be used in order to contain, reverse or burst bubbles early that are developing in asset markets. There is a subtle difference between this view and the Cecchetti/Wadhwani view in that Roubini proposes that the purpose of monetary policy should be the reversal of the asset-price bubble, rather than the existence of the bubble being an extra part of the information set used by central banks.

9.4 Asset prices and the conduct of monetary policy – concluding thoughts

Between them the “leaning again the wind” view, the Alchian and Klein thesis, the Austrian/monetarist interpretation and the “bubble pricking” view of the role of asset prices in monetary policy represent a substantial body of opinion. The “leaning against the wind” approach probably represents the greatest challenge to central bank orthodoxy at the current time. However, as the quotation above from Borio and White (2003) suggests, a central bank using a comprehensive model of the real economy and financial sector and a medium-term inflation forecasting framework with a flexible time horizon, may not, in practice, deviate far from a “leaning against the wind” approachFootnote ⁴¹.

All the approaches to giving asset market information a greater role in monetary policy setting have implications for actuaries:

• • The schools of thought that propose a greater role for asset prices in monetary policy setting would argue that the efficient markets’ hypothesis should be qualified, at least.

• • In one way or another, all these approaches posit a relationship between monetary policy and asset values and thus suggest that asset values might deviate from long-run fundamentals dictated by the real economy. This raises the issue of whether accounting conventions and regulations for going concerns should necessarily always be based on market values.

• • The “bubble pricking”, “leaning against the wind” and Alchian/Klein view suggest a wider role for asset prices in monetary policy. Such a wider role would change the context of inflation targeting as currently followed by many central banks and, potentially, change the transmission mechanism and the relationship between current policy and inflation expectations.

• • If a central bank took asset values into account when setting monetary policy and the above theories were correct, this action would reduce asset price volatility which would have implications for long-term asset-value modelling. If central banks were able to successfully reduce volatility in investment markets there would, of course, be wider benefits. However, if markets are broadly efficient and real factors tend to determine investment values, and/or central bankers are not able to distinguish increases in investment values caused by real factors and those caused by other factors, central banks could raise asset price volatility if they used monetary policy to attempt to “stabilise” asset markets.