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Wednesday, May 22, 2002

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Asset prices: The new monetary policy variable?

S. Balakrishnan

ASSET price inflation is the hottest topic in financial policy-making and markets today.

All these years, the world was focused on conventional inflation — increases in commodity prices and wages feeding through to other prices and raising the general price level. Defined this way, inflation has been on a distinct downward path for over a decade now — the phenomenon known as disinflation. Japan has even gone through a prolonged phase of negative inflation or deflation. Just as inflationary expectations frontload spending and investment and increase aggregate demand at a time of rising prices, worsening the price situation, anticipation of falling prices could decelerate current demand for goods and services. Thus, Japan has brought down interest rates to zero in an effort to make consumers and businesses spend here and now.

In the meanwhile, stock markets in the Western world, especially the US, skyrocketed to levels never seen before. At its peak, the Dow Jones Industrial Average crossed 11,000 and the Nasdaq hit 5,000. House price have also been strong, more so in Britain. These sharp increases in share and property prices go by the name of asset price inflation and have opened up a new source of concern for monetary policy makers, who have hitherto been content with monitoring traditional price indices, which do not, of course, include asset prices.

Influential central bankers are now lending their voices to adding asset price movements to the list of variables for determining monetary policy and interest rates. One of them is, Mr Sushil Wadhwani, a member of the MPC, the rate-setting body of the Bank of England. But the prima donna of central banking, Mr Alan Greenspan, Chairman of the US Federal Reserve, does not think the time is ripe yet for asset prices to have a significant say.

The world is changing. It is unlikely to see a return to high inflation. The increasing mobility of investment and other factors of production to low-cost locations and the big gains in technology, productivity and competition have combined to ensure that inflation is benign.

The other key thing to understanding the new economy (and economics) is that spending power is no longer dependent on current income or savings but wealth as measured by the market valuation of assets. If an individual owns his house and a portfolio of stocks, his financial position, strength and willingness to spend are more likely to be influenced by what they are worth in the marketplace than what he or she earns.

Asset price changes in financial and other markets significantly affect the balance sheets of consumers and businesses. These may very well be crucial to knowing and explaining the economic cycles of the future.

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