Pricking Bubbles in the Wind: Could Central Banks have done more to head off the Financial Crisis? Howard Davies Director, LSE The Annual David Finch Lecture The University of Melbourne 13 August 2009

Need and scope for discretionary fiscal stimulus Source: BIS Annual Report 2008/09 Size of fiscal packages 2009 GDP forecast

Scale of US Government Commitments Source: Silverlake, Bianco Research, The Times, Moodys Government ExpenditureCost (inflation adjusted) Marshall Plan115 Race to the Moon237 S&L Crisis256 Korean War454 The New Deal500 Invasion of Iraq597 Vietnam War698 NASA851 WW25000 Current Crisis (Pledged)12080

Global current account balances Source: IMF, FSA calculations

Source: The Economist, October Federal funds rate, actual and counterfactual, (in percent)

UK real interest rates (20 year bonds, yield at May 25 or nearest week day) Source: Bank of England Real Yield curve calculations

Household debt/ disposable income Source: BIS Annual Report 2008/09

Mortgage debt outstanding (UK) Source: Bank of England

Five Questions 1. Should central banks target asset prices?

Five Questions 1.Should central banks target asset prices? 2.Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

Including house prices in the US inflation measure Personal consumption expenditure inflation Source: Ceccheti, National Institute Economic Review, No.196, April 2006

The UK retail price index Source: Ceccheti, National Institute Economic Review, No.196, April 2006

Five Questions 1.Should central banks target asset prices? 2.Should the measure of inflation targeted include an element of asset price, and particularly house price inflation? 3.Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

Five Questions 1.Should central banks target asset prices? 2.Should the measure of inflation targeted include an element of asset price, and particularly house price inflation? 3.Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers? 4.Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion and bring forward the adjustment?

Five Questions 1.Should central banks target asset prices? 2.Should the measure of inflation targeted include an element of asset price, and particularly house price inflation? 3.Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers? 4.Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion and bring forward the adjustment? 5.Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?

Conclusions 1.Central banks must pay more attention to asset price bubbles than they have in the past

Conclusions 1.Central banks must pay more attention to asset price bubbles than they have in the past 2.Asset prices should be identified as an explicit factor in the consideration of policy

Conclusions 1.Central banks must pay more attention to asset price bubbles than they have in the past 2.Asset prices should be identified as an explicit factor in the consideration of policy 3.A statutory financial stability objective may encourage the central bank to take credit and asset prices into account

Conclusions 1.Central banks must pay more attention to asset price bubbles than they have in the past 2.Asset prices should be identified as an explicit factor in the consideration of policy 3.A statutory financial stability objective may encourage the central bank to take credit and asset prices into account 4.A second instrument – macroprudential adjustments in capital ratios – may help, but must be looked at alongside interest rate decisions, as the economic effect may be similar.

Pricking Bubbles in the Wind: Could Central Banks have done more to head off the Financial Crisis? Howard Davies Director, LSE The Annual David Finch Lecture The University of Melbourne 13 August 2009