The Market Forest Fire Analogy

By October 24, 2017 Blog

      Fire fighters often complain about the downside of fire prevention.  By preventing small fires, the fuel for large ones continues to accumulate and dry out.  Then when conditions are right – hot days and high winds – conflagrations can occur.  This “boom and bust” fire cycle has been a continued problem in my home state of California.

      The interesting question is, does the same logic apply to central banks and asset price busts?  For instance, in the years leading up to 2000 and 2008, central bank policy was loose and asset prices rose sharply.  (Tech stocks in the years before 2000 and housing prices in the years before 2008.)  John Taylor, currently one of the leading candidates for Chairmanship of the Fed, argues that had the Fed followed his rule and tightened in 2004/2005, the housing collapse and associated great recession could have be alleviated or avoided.

      This leads to the question of whether the Fed should target asset prices.  The standard answer has been no.  The Fed should target inflation in consumer prices, but not asset prices.  But in recent times, it has been booms and busts in asset prices that have caused most of the economic damage.  It is not surprising, therefore, that a debate has arisen in academic circles over the targeting of asset prices.  Given my view expressed in this blog that asset prices are again approaching unsustainable levels, driven in my by investors reaching for yield and taking on more leverage, I find the argument that the Fed should pay attention to asset prices increasingly convincing.