Andrew Smithers & Stephen Wright.
World Economics Vol 3 No. 1 January-March 2002, 1st January 2002
Introduction
The current troubles of the US economy, and the prolonged problems in Japan, have both followed sharp falls in their stock markets. Whether central bankers should respond to fluctuations in share prices has thus become an important issue of economic policy. The question is whether the Bank of Japan, during the 1980s, and the Federal Reserve, in the 1990s, should have tightened monetary policy in an effort to stem their stock market booms.
On 5 December 1996, Fed Chairman Alan Greenspan remarked that the level of the US stock market suggested that investors had become imbued with “irrational exuberance”. The phrase became famous and was subsequently used by Robert Shiller (Shiller, 2000) as the title of his bestselling book on the overvaluation of the US market. Alan Greenspan’s concerns, however, did not appear to linger long in his mind. Indeed, as the market continued to rise well beyond the levels at which he had expressed his initial concerns, Greenspan appeared to move from critic to cheerleader.
As we write, the US stock market has fallen by around one-third from its peak level. It is widely believed that the US economy is already in recession and there are widespread concerns that this will deepen. The economy has yet to respond to the dramatic falls in interest rates that have been made by the Fed and there are thus fears that the US could follow Japan into a liquidity trap. It is therefore reasonable to ask whether these problems could have been avoided had Alan Greenspan acted on his initial concerns. This, in turn, raises the broader question of whether central banks should in general respond to stock market movements.
Full paper: Stock Markets & Central Bankers The Economic Consequences of Alan Greenspan [2002]