The gut instinct of the critics is that rates would have been lower if the MPC had to moderate fluctuations

The gut instinct of the critics is that rates would have been lower if the MPC had to moderate fluctuations in growth as well as hit an inflation target.Certainly, the strong exchange rate has been a powerful argument for keeping interest rates lower than they might otherwise have been. The report argues that when an overvalued exchange rate is due to a portfolio shift – and does not simply reflect stronger demand growth in the country affected – the level of loan costs should be set according to an indicator of monetary conditions that in effect takes a weighted average of interest rates and the exchange rate. A stronger pound would point to lower interest rates if the MPC were using a monetary conditions index The catch is in the caveat. To set an ideal policy, the central bank has to know what has caused the exchange rate appreciation, and be sure that it is not mainly a reflection of the stage of the business cycle.

There must be a good pragmatic argument for making some allowance for a fundamentally overvalued pound, but that is not the same as a good argument for using a combined interest rate-exchange rate policy at all times, regardless of the reasons for the currency’s strength.A separate section of the report looks at share prices, and argues that central banks also set a better policy when they raise interest rates to pre-empt stock market bubbles. Taking account of the future effects of share price moves also contributes to greater macroeconomic stability. Central banks have to be able to estimate when there is a bubble, of course, but then they have to estimate all sorts of things anyway. This is a problem in practice rather than in principle.However, it is not obvious what the ideal interest rate rule ought to be when asset prices send different signals, as they have in the US and UK in recent years. Stock market bubbles (perhaps) have gone hand-in-hand with exchange rate over-valuations, as the charts indicate, and indeed it seems likely there is a causal link. The currencies have almost certainly risen in good part because investors wanted to buy equities and other assets in dollars and sterling.The separate asset prices alone could not have guided policy decisions, and interest rates would probably not have been very different with an asset price-augmented inflation target. Making judgements about the particular context has been unavoidable in recent years.If anything, the members of the MPC and Fed Open Market Committee have been much easier-going on the level of rates than if they had been using an economic model to do their job for them.

The academic rules have pointed to interest rates, both higher and more volatile, than has actually been the case. Central bankers are far more cautious in practice than they ought to be in theory And their judgements seem to have paid off. Both the US and UK have enjoyed many years of stable growth and low and steady inflation. The balance of growth could definitely improve, but as macroeconomic performances go, it could have been a lot worse.Asset Prices and Central Bank Policy, ed Cecchetti, Genberg, Lipsky and Wadhwani, CEPR and ICBM. see www.cepr for details.d.coyle independent.co.uk. Vadim Jean

Vadim Jean. Some years ago, the current Liverpool FC manager, Gérard Houllier, was a French assistant teacher at the school I went to, namely Alsop Boys’ School in Walton, Liverpool.