That might suggest that interest rates should have been lower. Equity prices rose by 120% between 1995 and 2000, before falling 40% subsequently. Presumably that would have implied first higher and then lower interest rates. What this means is that asset prices cannot sensibly be viewed in isolation, but only in the context of the economy as a whole. I believe that, although there are justifiable concerns about recent movements in asset prices, the policy dilemma can be analysed within the framework of inflation targeting that we have in the UK. No honest person actually knows the “equilibrium” level of asset prices. They are dominated by expectations of the prices that other investors will pay for those assets in future. The relevant uncertainties can rarely be quantified by observing the frequencies of events in the past. And the response of asset prices to changes in monetary policy is also unpredictable. So targeting asset prices directly is virtually impossible. But changes in asset prices can have a major impact on levels of spending and the MPC devotes considerable time to the question of how such changes should affect policy. 6  Electrical appliances and audio-visual equipment share was 0.021 in 1956 and was 0.018 in 2002. 7  See Boskin M et al (1996) ‘Towards a More Accurate Measure of the Cost of Living’. Final report to the Senate Finance Committee from the Advisory Committee to Study the Consumer Price Index. 8  The most rigorous statement of the case for stabilising asset prices is Dupor (2002).
And if many firms make these mistakes at the same time then the result is an unnecessary fluctuation in aggregate output. Another decision affected by uncertainty about prices is investment. Many investments are specific to a particular model or product, and so they become sunk costs. For such irreversible investments it may pay to wait before investing since time will resolve some of the uncertainty. A Premiership football team may decide to postpone the construction of a new stadium until their survival in the League is assured. Or a car manufacturer may postpone a decision about opening a new plant to see if a rise in demand is temporary or appears likely to last. And that uncertainty could stem from a difficulty in disentangling relative from absolute prices. In the language of finance, there is an option value to waiting when there is uncertainty about the returns on an irreversible investment. So a project must offer a rate of return sufficient not only to cover the cost of financing of the project, but also the option value to waiting. That may explain why surveys of firms show that their hurdle rates of return are often well in excess of the cost of either equity or debt finance. For example a CBI survey last year found that the average real hurdle rate for UK firms was 11.3% - down from rates of around 15% in surveys conducted in 1994 - but still well above the cost of financial capital.