“Helicopter money” – reality bites BIS, by Mr Claudio Borio

Since the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. The measures have gone far beyond the typical pre-crisis mode of operation – controlling a short-term policy rate and moving it within a positive range – and have therefore come to be known as “unconventional monetary policies.” To be sure, some of these measures had already been pioneered by the Bank of Japan roughly a decade earlier in the wake of that country’s banking crisis and uncomfortably low inflation. But no one had anticipated that they would spread to the rest of the world so quickly and become so daring, testing the boundaries of the unthinkable.

As growth has remained disappointing and inflation stubbornly below targets, the range and size of these measures have increased. Hence the growing use of long-term liquidity support, large-scale asset purchases, sizable increases in bank reserves (so-called QE) and, of late, even the introduction of negative policy rates. In the wake of these measures, the central banks’ monetary base (cash and bank reserves) has ballooned in step with the overall size of their balance sheets (see graph). 

With central banks delving further down into their box of unconventional tools, calls for them to take a deep breath and pull out “helicopter money” have intensified. What was just a thought experiment designed to shed light on how money affects the economy is now threatening to become a reality. Proponents of this tool – more soberly described as “overt money financing” of government deficits – see it as a sure-fire way to boost nominal spending by harnessing central banks’ most primitive power: their unique ability to create money at will. But can helicopter money work in the way its proponents claim? And is the balance of benefits and costs worth it? Our answer to both of these questions is no.

Proponents argue that helicopter money is special because it amounts to a permanent increase in non-interest bearing central bank liabilities (“money”) as the counterpart of the deficit. This form of financing is most effective because money is free and debt is not. Permanent monetary financing means less government debt and thus lower interest payments forever. All else equal, this saving should boost nominal demand, as there would be no need to raise additional taxes. Moreover, the argument continues, the central bank is then free to increase interest rates again whenever it wishes while the lower amount of debt outstanding will still yield savings. This is the best of all possible worlds: Demand is boosted without the collateral damage of prolonged exceptionally low interest rates.

Devil in the details

Or so it seems. But the devil is in the details.

As we have argued elsewhere, the reasoning may be correct in the stripped-down models people have in mind, but not in reality. In fact, the central bank faces a stark choice: Either helicopter money results in interest rates permanently at zero, so that control over monetary policy is lost forever, or else it is equivalent to either debt or to tax-financed government deficits, in which case it would not yield the additional boost. Since losing monetary policy control forever is not a feasible option, helicopter money is just fiscal policy dressed up.

The reason is hidden in an obscure but critical corner of the financial market. Contrary to what the stylized models suggest, it is not the amount of cash that determines interest rates but what the central bank does with bank reserves (commercial banks’ deposits at the central bank), over which it has a monopoly. Monetary deficit financing will, in effect, amount to an equivalent increase in bank reserves. If the central bank issued more cash than people demanded, the amount in excess of desired balances would inevitably be converted into bank deposits and then switched by banks into reserves (see in the graph how steadily and slowly cash grows, reflecting the demand for it). If the government issued checks, the same would happen. If the reserves are non-interest bearing – as they must be for helicopter money – the increase will inevitably also drive the short-term (overnight) rate to zero. This is because when the system as a whole has an excess of reserves, no one wants to be left holding it but someone must.

The problem arises once the central bank decides to raise interest rates again, as this, alas, would not be consistent with helicopter money. To do so, the central bank has only two options. Either it pays interest on those reserves at the policy rate, in which case this is equivalent to debt financing from the perspective of the consolidated public sector balance sheet – there are no interest savings. Or else it imposes a non-interest bearing compulsory reserve requirement to absorb the reserves, but this is equivalent to tax financing – someone in the private sector must bear the cost. While the tax would in the first instance fall directly on banks, they could decide to pass it on to their customers — for example, in the form of higher intermediation spreads.

Thus, either helicopter money comes at a prohibitive price – giving up control over monetary policy forever – or else, choreography and size aside, in its watered-down version it is not very different from what some central banks have already been doing: engineering temporary increases in reserves which may happen to coincide with increases in government deficits (a form of QE). Views about QE’s effectiveness differ, but we would be talking about “more of the same.” Such a policy already exploits the synergies between ultra-low interest rates and fiscal policy so as to enhance any expansionary impact that fiscal policy may have.

That said, choreography and size do matter. And they don’t speak in favor of the tool. Imagine policymakers went down this route, announcing that they were embarking on a “new” policy and explicitly linking the increase in reserves with higher public sector deficits. They could hide the inconvenient truth and renege on their promise not to raise rates. But this would hardly be an example of good policy, and in any case its effectiveness would at best be doubtful – the private sector would surely anticipate this possibility to some extent, thereby tempering the impact of the signal. Alternatively, policymakers could hope that the fanfare surrounding the tool would induce people to spend more. This is a possible but by no means obvious outcome. And in any case, unless the exercise is repeated over and over again on a large scale, its impact is likely to be only temporary.

And therein lies the danger. It is hard to imagine helicopter money not ending up in fiscal dominance, the outcome that would obviously be inevitable in its purest form, where interest rates are kept at zero forever. Sooner or later this could indeed erode the value of money, but at the cost of losing the public’s confidence in our monetary institutions – a trust so painfully gained over the years – and with unpredictable consequences. It would be a Pyrrhic victory.

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Do we need the Fed? by Ron Paul

Stocks rose Wednesday following the Federal Reserve’s announcement of the first interest rate increase since 2006. However, stocks fell just two days later. One reason the positive reaction to the Fed’s announcement did not last long is that the Fed seems to lack confidence in the economy and is unsure what policies it should adopt in the future.

At her Wednesday press conference, Federal Reserve Chair Janet Yellen acknowledged continuing “cyclical weakness” in the job market. She also suggested that future rate increases are likely to be as small, or even smaller, then Wednesday’s. However, she also expressed concerns over increasing inflation, which suggests the Fed may be open to bigger rate increases.

Many investors and those who rely on interest from savings for a substantial part of their income cheered the increase. However, others expressed concern that even this small rate increase will weaken the already fragile job market.

These critics echo the claims of many economists and economic historians who blame past economic crises, including the Great Depression, on ill-timed money tightening by the Fed. While the Federal Reserve is responsible for our boom-bust economy, recessions and depressions are not caused by tight monetary policy. Instead, the real cause of economic crisis is the loose money policies that precede the Fed’s tightening.

When the Fed floods the market with artificially created money, it lowers the interest rates, which are the price of money. As the price of money, interest rates send signals to businesses and investors regarding the wisdom of making certain types of investments. When the rates are artificially lowered by the Fed instead of naturally lowered by the market, businesses and investors receive distorted signals. The result is over-investment in certain sectors of the economy, such as housing.

This creates the temporary illusion of prosperity. However, since the boom is rooted in the Fed’s manipulation of the interest rates, eventually the bubble will burst and the economy will slide into recession. While the Federal Reserve may tighten the money supply before an economic downturn, the tightening is simply a futile attempt to control the inflation resulting from the Fed’s earlier increases in the money supply.

After the bubble inevitably bursts, the Federal Reserve will inevitability try to revive the economy via new money creation, which starts the whole boom-bust cycle all over again. The only way to avoid future crashes is for the Fed to stop creating inflation and bubbles.

Some economists and policy makers claim that the way to stop the Federal Reserve from causing economic chaos is not to end the Fed but to force the Fed to adopt a “rules-based” monetary policy. Adopting rules-based monetary policy may seem like an improvement, but, because it still allows a secretive central bank to manipulate the money supply, it will still result in Fed-created booms and busts.

The only way to restore economic stability and avoid a major economic crisis is to end the Fed, or at least allow Americans to use alterative currencies. Fortunately, more Americans than ever are studying Austrian economics and working to change our monetary system.

Thanks to the efforts of this growing anti-Fed movement, Audit the Fed had twice passed the House of Representatives, and the Senate is scheduled to vote on it on January 12. Auditing the Fed, so the American people can finally learn the full truth about the Fed’s operations, is an important first step in restoring a sound monetary policy. Hopefully, the Senate will take that step and pass Audit the Fed in January.

America’s Endless War Over Money, K. Granville and B. Applembaum (via NYT, 08/04/2015)

 

The “Audit the Fed” debate is the latest manifestation of a conflict as old as the nation, between those who argue that a strong central bank improves economic stability, and those who see an overbearing government engaged in harmful meddling.

Some Background: Strong vs. Weak Currency

Battles over central banking have historically pitted financial elites who wanted to limit the availability ofmoney, thus preserving its value, against farmers, businessmen and other borrowers who wanted money to be plentiful — and cheap. Each side has sometimes regarded the central bank as its great ally in that fight, and sometimes as its bitter enemy.

Since the Great Recession the Fed has mostly sided with the borrowers, creating vast amounts of newmoney and holding short-term interest rates near zero. Inevitably, that has angered creditors, and sparked efforts to swing the pendulum in the other direction.

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A cartoon satirizing Andrew Jackson, shown raising a cane labeled “veto,” and his battle against the Bank of the United States and its supporters among state banks.

1. A Philadelphia Story: The Banks of the United States

The nation’s first two central banks, both called the Bank of the United States, were private, for-profit organizations chartered by Congress. The first (1791-1811) was created to help the government pay its Revolutionary War debt, stabilize the country’s currency and raise money for the new government. It was the dream of Alexander Hamilton, secretary of the Treasury, who overcame resistance from Thomas Jefferson (who wrote “I believe that banking institutions are more dangerous to our liberties than standing armies”) and other Southern lawmakers. When its 20-year charter expired, Congress chose not to renew it.

The Second Bank of the United States was chartered a few years later, in the aftermath of the War of 1812, after Congress decided it had a mistake. But it lasted just 17 years. President Andrew Jackson said the bank concentrated too much economic power with a corrupt moneyed elite and vetoed a bill to extend its charter in 1832. Supporters of the the bank rallied around Henry Clay, Jackson’s opponent for reelection that year, but the “Bank War” ended when Jackson won easily. United States Treasury funds were withdrawn and deposited in state banks; the nation would be without a central bank for more than 70 years.

The headquarters of both banks still stand about a block apart in downtown Philadelphia.

“The bank is trying to kill me, but I will kill it!”—Andrew Jackson.

 

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Crowds gather across the street from a failed New York bank in 1908. CreditGeorge Grantham Bain Collection/Library of Congress

2. Perpetual Panic: Life Without a Central Bank

A severe financial crisis drove the economy into a deep recession in 1837, just one year after the demise of the Second Bank. Such crises became a recurring event in American life and, as the economy grew, so did their size and the frequency. Banks created the New York Clearing House as a private-sector backstop, but it proved inadequate for the task. The government also was hamstrung. In the absence of a central bank, the United States regulated the value of its currency by guaranteeing that dollars could be exchanged for gold, and sometimes silver. This meant the government could not respond to financial crises, and the resulting economic downturns, by increasing the supply of money.

In 1907, yet another crisis was brought about by a failed attempt to corner the stock of the United Copper Company. Government officials and financial executives jerry-rigged a response: an emergency lending pool orchestrated by J. Pierpont Morgan. But the crisis proved to be a tipping point in the political debate about the need for a central bank. There was a growing political consensus that Wall Street needed a permanent fire department.

“Unless we have a central bank with adequate control of credit resources, this country is going to undergo the most severe and far reaching money panic in its history.”—Jacob Schiff, a prominent New York banker, in 1907

 

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President Woodrow Wilson signing the Federal Reserve Act of 1913, in a painting by Wilbur G. Kurtz Sr. He is surrounded by members of his cabinet and Congressional leaders. CreditWoodrow Wilson Presidential Library, Staunton, Va.

3. Third Time’s the Charm: The Federal Reserve Act of 1913

In November 1910, Senator Nelson Aldrich met with a group of bankers at a resort on Georgia’s Jekyll Island and hammered out a plan for a new central bank. The idea touched on many of the great political battles of the age: The states against Washington; Wall Street financiers against smaller banks, particularly in the South and West; populists against the Gilded Age elite. The bill that emerged from several years of debate, signed by President Woodrow Wilson, was an awkward compromise: There would be 12 privately owned reserve banks in major cities across the country, preserving the power of financial elites. But the banks would be overseen by a board of presidential appointees, including the Treasury secretary, granting the public a new measure of control over the financial system.

Before the Fed was fully established, however, the old system took a final bow. A financial crisis struck in 1914, and roughly twice as many banks failed as in 1907.

“We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon; and step by step we shall make it what it should be.”—Woodrow Wilson, from his first inaugural address

 

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In 1933, after some banks limited withdrawals to 5 percent or less, customers waited to enter the National City Bank in Cleveland. CreditAssociated Press

4. Recession and Response

Instead of preventing crises, the Federal Reserve helped to cause the Great Depression. The Fed was supposed to manage the gold standard — to make sure the economy was not choked by a lack of moneyand a resulting spike in interest rates. Instead, the Fed was paralyzed by disagreements between regional banks and the central board. It let the money supply shrink by one-third. The result was the worst economic crisis in the nation’s history.

Congress responded to the Fed’s failure by greatly increasing its power and responsibilities. In 1934 it authorized the president to devalue the dollar, beginning the long process of replacing the gold standard with a currency whose value is managed by the Fed. In 1935 it gave the Fed responsibility for “the general credit situation of the country.” The act also removed the Treasury secretary from the Fed’s board and created a new policy-making committee where board members would outnumber reserve bank presidents.

“I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”—Ben Bernanke, then a Fed governor, in a 2002 speech addressing Milton Friedman and Anna Schwartz.

 

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The Federal Open Market Committee in 1966, led by the Fed chairman, William McChesney Martin, seated center. CreditFabian Bachrach

5. The Long Road to Independence

The central bank now had the freedom to encourage growth by printing money, and the responsibility not to print too much. Politicians who were focused on short-term problems were quick to demand money and, for the next several decades, the Fed hesitated to say no.

In 1942, at the request of the Treasury Department, the Fed agreed to hold down interest rates on government bonds to help finance military spending for World War II. It kept rates low for almost a decade, through the beginning of the Korean War, until rising inflation finally induced the Treasury to sign a 1951 accord affirming the Fed’s autonomy to raise rates.

In the 1960s, Wright Patman, a populist Democrat congressman from Texas and chairman of the House banking committee, repeatedly introduced legislation to roll back the Federal Reserve Act of 1913, maintaining that, in the Fed, “a body of men exist who control one of the most powerful levers moving the economy and who are responsible to no one.”

And in 1965, President Lyndon B. Johnson, who wanted cheap credit to finance the Vietnam War and his Great Society, summoned Fed chairman William McChesney Martin to his Texas ranch. There, after asking other officials to leave the room, Johnson reportedly shoved Martin against the wall as he demanding that the Fed once again hold down interest rates. Martin caved, the Fed printed money, and inflation kept climbing until the early 1980s.

“I hope you have examined your conscience and you’re convinced you’re on the right track.”—Lady Bird Johnson, spoken to William McChesney Martin, on his arrival at the LBJ ranch.

 

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Paul A. Volcker, shown in 2009. He was appointed Fed chairman in 1979 with the task of controlling galloping inflation. CreditBrian Snyder/Reuters

 

6. The Volcker Rule: An Independent Central Bank

Congress finally formalized its demands in 1978. A recession in the mid-1970s had pushed the unemployment rate as high as 9 percent, and Democrats, frustrated by what they saw as the Fed’s inadequate response, won passage of legislation establishing the so-called dual mandate. The Fed was instructed to pursue maximum employment and price stability.

It turned out to be a high-water mark for Congressional interference. Inflation rose by 11 percent the following year, and President Jimmy Carter agreed to appoint a new Fed chairman, the independent-minded Paul A. Volcker. Over the next several years, Mr. Volcker would raise interest rates sharply, driving the economy into a deep recession but ultimately bringing inflation under control. President Ronald Reagan, meanwhile, made a point of respecting the Fed’s independence. Volcker was still subjected to sharp Congressional pressure, but it was mostly political theater. The Fed had declared its independence.

“Every time he had a press conference somebody was urging him to take a slap at the Federal Reserve, but he never did.”—Paul Volcker, referring to President Reagan.

 

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Ben Bernanke, the Fed chairman, takes questions from reporters at an April 2011 news conference. CreditJim Watson/Agence France-Presse — Getty Images

 

7. Smokescreens and Sunshine: The Fed Opens Up

Between the great inflation of the early 1980s and the Great Recession that began in 2008, the Fed and the economy enjoyed more than two decades of relative peace and quiet, a period that Fed officials sometimes call the Great Moderation. Inflation trended downward and, except for a few short recessions, unemployment stayed down too. And Fed officials came to see these trends as a validation of their newfound independence.

The Fed also began to change its secretive culture. The trend began reluctantly, under pressure from critics who argued that independence required transparency. In 1983, for example, the Fed promised Congress that it would begin to release its Beige Book, a summary of economic reports from its regional reserve banks, as a way of distracting attention from more important reports that it was determined to keep secret. But the Fed gradually concluded that transparency could increase the power of monetary policy. In 1994, it began to announce changes in policy at the end of each policy-making session. In 2004, it began to publish edited accounts of its discussions three weeks after each session. And in 2011, its chairman, Ben S. Bernanke, began to hold quarterly news conferences.

“Since I’ve become a central banker, I’ve learned to mumble with great coherence. If I seem unduly clear to you, you must have misunderstood what I said.”—Alan Greenspan, Fed chairman, in 1987, before the central bank’s communications revolution.

“The Federal Reserve is the most transparent central bank to my knowledge in the world. We have made clear how we interpret our mandate and our objectives and provide extensive commentary and guidance on how we go about making monetary policy decisions.”—Janet L. Yellen, Fed chairwoman, in 2014, after the communications revolution.

 

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Protesters in April 2009, outside an event where Ben Bernanke, the Fed chairman, was speaking. CreditJason Miczek/Reuters

 

8. The Great Recession, and ‘Audit the Fed’

The Fed’s long run as a political darling came to a crashing end in 2008. Its lax oversight of the financial system was one reason for the severity of the crisis, and the smartest guys in Washington had failed to see it coming. The Fed’s response was also controversial: It provided expansive support for the financial system, preserving some of America’s least popular companies, not to mention foreign banks. And then it embarked on an expansive stimulus campaign to revive the economy.

In the aftermath of the crisis, Congress moved quickly to strengthen the Fed’s regulatory responsibilities. It also imposed some limits on the Fed’s ability to repeat its rescue of the financial system. But it is the stimulus campaign that has prompted the most controversy.

In an inversion of the historical pattern, congressional Republicans have criticized the Fed for printing too much money, arguing higher inflation will be the inevitable consequence. And they have put forward proposals to constrain the central bank. One bill, known as “Audit the Fed,” would authorize the General Accountability Office to review the Fed’s monetary policy decisions. Another approach, backed by the House Financial Services Committee, would require the Fed to publicly articulate a set of rules it intends to follow in making monetary policy, and then explain any deviations.

“The Federal Reserve System must be challenged. Ultimately, it must be eliminated. The government cannot and should not be trusted with a monopoly on money. No single institution in society should have power this immense.”—From End the Fed (2009) by Ron Paul.

The Federal Reserve Asset Bubble Machine (by Ruchir Sharma, WSJ)

Easy money is driving up the price of stocks, bonds, houses and other assets in a era without historical precedent.

Janet Yellen’s comment last week at the International Monetary Fund headquarters in Washington, D.C., that stock prices are “quite high” hardly captures the frothiness in U.S. financial markets. The Federal Reserve chair’s admission also stopped short of acknowledging the role of free money in inflating the price of stocks—as well as the price of bonds, houses and every other financial asset.

At Morgan Stanley Investment Management, we have analyzed data going back two centuries and found that until the past decade no major central bank had ever before set short-term interest rates at zero, even in periods of deflation.

To critics who warn that pumping trillions of dollars into the economy in a short period is bound to drive up inflation, today’s central bankers point to stagnant consumer prices and say, “Look, Ma, no inflation.” But this ignores the fact that when money is nominally free, strange things happen, and today record-low rates are fueling an unprecedented bout of inflation across asset prices.

The Fed’s defenders quibble that houses are less pricey than in the bubble of 2007, or that stocks are less pricey than in 2000, which misses the difference this time around. In the past 50 years, valuations of U.S. stock prices have been higher than they are now for less than 10% of the time, and similar figures hold for bonds and houses. This kind of synchronized boom has never happened, not even before the last two major meltdowns. My research team’s composite valuation for the three major financial assets in America—stocks, bonds and houses—is currently well above levels reached during the bubbles of 2000 and 2007.

Faith in the Fed’s easy-money policies has encouraged a dangerous complacency. The mantra on Wall Street is that good economic news is good news for the markets, but that bad news is also good news, because it will encourage the Fed to keep rates lower for longer. This has led to one of the longest rallies the U.S. stock market has ever experienced, without even a 10% correction. Returns since 2012 are the highest for any three-year period in recorded history, after adjusting for the risk of holding stocks.

The Fed’s approach has spread to central banks in Europe, Japan and China, creating a new world in which investment decisions are guided by the availability of easy money, not opportunity. Over the past three years, global stock prices have risen rapidly despite tepid economic growth. Oh well, the central bank responds: We target consumer prices, not assets.

This job description is outdated, because the task is largely done. In emerging nations, the average annual growth of consumer prices now hovers around 5%, down from a peak of 116% in 1994. Add in the rich countries, which are generally more stable, and global inflation has fallen to 2% today from near 20% in the early 1970s.

Central bankers are still fighting to control consumer prices, only now for the opposite reason. Rather than raising interest rates to contain consumer spending and inflation, they hold rates down to encourage spending and induce inflation, because the global inflation rate of 2% is dangerously low in their view. The fear is that slowly rising prices will tip into falling prices. The boogeyman is not hyperinflationary Germany of the 1930s, but deflationary Japan of the 1990s, when the country fell into a downward spiral of falling prices, weak demand and stagnant growth.

Japan taught the world two lessons: that consumer price deflation is bad for growth and that it is hard to shake. Both are inaccurate. Before World War I, many nations experienced deflation, sometimes driven by weak demand and leading to weak growth, but as often driven by rising productivity and accompanied by strong growth.

A recent Bank for International Settlements study on the postwar period found that long bouts of deflation were exceedingly rare, but short bouts were common. More important, average annual GDP growth was roughly the same regardless of whether prices were rising or falling. The upshot: Consumer price deflation is not necessarily bad for growth.

One problem is that the world changed faster than the Fed. Trade has jumped to 60% of global GDP from 40% in 1980, and increasing competition puts downward pressure on consumer prices. The forces of expanding supply from China to Mexico are pushing the global average inflation rate down to a level that looks scary low only when compared with the 1970s highs. In fact, consumer price inflation is still above the long-term average, dating to the year 1200, which is 1%.

But global competition wields the opposite effect on asset prices. The opening of financial markets means that many more buyers are bidding up prices for stocks in New York, or real estate in Miami or bonds in Chicago. The result is that central banks are unleashing easy money to fight an imaginary villain, consumer price deflation, at the risk of feeding a real monster, asset price inflation.

Every major economic shock in recent decades has been preceded by an asset bubble: housing and stocks both before Japan’s meltdown in 1990 and before the Asian financial crisis in 1998; stocks before the U.S. dot-com bust in 2000; housing again before the crisis in 2008. Strikingly, even as asset prices were climbing before the busts of 2000 and 2008, the Fed kept monetary policy loose because consumer prices were rising only moderately. That is the same excuse we hear now, amid a price boom in stocks, houses and bonds.

It is true that bubbles are most dangerous when people are borrowing heavily, and are buried by debt when the bubble collapses. Because U.S. households have been cutting debt, Ms. Yellen says the situation is not unduly risky. But U.S. corporations are borrowing heavily, and not all bubbles are fed by rising debt.

The Fed now leads a culture of central bankers who see their job as reducing unemployment and stabilizing prices for consumer goods only, come what may in the markets. This needs to change. In a world in which high trade and money flows tend to restrain consumer prices but magnify asset prices, central banks need to take responsibility for both. After all, asset price inflation is as dangerous as consumer price inflation.