Monetary policy should eye credit growth: paper at Fed summit

JACKSON HOLE, Wyoming (Reuters) - Central banks should consider the growth of credit, not just inflation, when figuring out the right level of interest rates, according to a paper presented at the closely-watched Federal Reserve summit.

The study, led by Northwestern University economist Lawrence Christiano, found that stock market booms are, counterintuitively, accompanied by quite weak inflation.

So if policymakers were to rely on conventional models, which focus primarily on inflation expectations, they might cut interest rates and unduly boost excess optimism about share prices.

"A monetary policy which implements inflation forecast targeting using an interest rate rule would actually destabilize asset markets," the authors argue.

"The lower-than-average inflation of the boom would induce a fall in the interest rate and thus amplify the rise in stock prices."

The paper suggests that those who criticized the Fed for fueling the global financial crisis by keeping rates too low for too long may have a point.

Of course, the Fed's current predicament is quite different.

Officials gathered at Jackson Hole, Wyoming, for the central bank's annual retreat will be debating the prospect that a weakening U.S. recovery might require further monetary easing, at a time when official interest rates are already effectively at zero.

But the paper's findings are relevant to an ongoing debate about whether the Fed can and should attempt to lean against asset bubbles by raising interest rates when prices in specific markets look to be getting ahead of themselves.

The authors stopped short of advocating such an approach, but they do suggest that central bankers need to be more mindful of lending patterns than they have been in the past.

"If credit growth is added to the interest rate targeting rules, the resulting rule will tend to smooth out stock market fluctuations," the authors say.

(For more stories on the Fed and the summit, see

(Reporting by Pedro Nicolaci da Costa; Editing by Kim Coghill)