FRBSF Economic Letter
2005-18; August 5, 2005
Monetary Policy and Asset Price Bubbles
In theory at least, an asset price
can be separated into a component determined by underlying
economic fundamentals
and a nonfundamental bubble component that may reflect
price speculation or irrational investor euphoria or depression.
The expansion of an asset price bubble may lead to a debilitating
misallocation of economic resources, and its collapse may
cause severe strains on the financial system and destabilize
the economy.
Despite these potential problems, the appropriate
monetary policy response to an asset price bubble remains
unclear
and is one of the most contentious issues currently facing
central banks. Some have argued that monetary policy
should be used to contain or reduce an asset price bubble
in order
to alleviate its adverse consequences on the economy,
while others have argued that such a policy would be both
impractical
and unproductive given real-world uncertainties about
the nature or even existence of bubbles. This Economic
Letter examines how policymakers
might choose between alternative courses of action when
confronted with a possible asset
price bubble.
Two monetary policy responses
Two general monetary policy
responses to movements in an asset price have been proposed.
I refer to the first
as "Standard
Policy," because there is widespread agreement
that it represents the appropriate baseline policy
response.
The Standard Policy responds to an asset price only
insofar as it conveys information to the central
bank about the
future path of output and inflation—the goal variables
of monetary policy. For example, a booming stock
market is usually followed by stronger demand and
increased
inflationary pressures, so tighter policy would be
needed to offset
these consequences. Even for the Standard Policy
response, it would probably be useful to identify—if
possible—the
separate fundamental and bubble components of the
asset price. In particular, the bubble component
may exhibit
more volatile dynamics and be a pernicious source
of macroeconomic risk, so optimal monetary policy
may
react more to bubbles
than to movements in the fundamental component.
The
second type of response, the "Bubble Policy," follows
the Standard Policy as a base case, but, in certain
circumstances, it also takes steps to contain or
reduce the asset price
bubble. Proponents of a Bubble Policy argue that
movements in the bubble component can have serious
adverse consequences
for macroeconomic performance that monetary policy
cannot readily offset after the fact, so it is preferable
for
central banks to try to eliminate this source of
macroeconomic fluctuations directly. Furthermore,
because bubbles often
seem to display a self-reinforcing behavior, a little
prevention early on can avoid later excesses.
For
example, under ideal circumstances, a policymaker
could recognize an expanding asset price bubble.
In this case,
the Standard Policy would recommend higher interest
rates to offset any economic stimulus generated
by the bubble.
A Bubble Policy would go further and try to reduce
the size of the bubble—probably by setting interest
rates
even higher; in doing so, the Bubble Policy would
likely trade off near-term deviations from the
central bank's
macroeconomic goals for better overall macroeconomic
performance later on. The fundamental difference
between the two policies
is that the Standard Policy takes the bubble component
essentially as given or exogenous, while the Bubble
Policy takes into account how the policy instrument
can influence
the bubble.
Choosing between Standard and Bubble
Policies
A decision tree for choosing between the Standard
and Bubble Policies is shown
below. In brief,
it poses
three questions:
(1) Can policymakers identify a bubble? (2)
Will fallout from a bubble be significant and hard
to rectify after
the fact? and (3) Is monetary policy the best
tool to deflate the bubble?
The first hurdle—Can policymakers
identify a bubble?—considers whether the particular
asset price appears aligned
with fundamentals. Some have argued that
either bubbles don't
exist because asset prices reflect the collective
information and wisdom of traders in organized
markets or, even
if they do exist, they cannot be identified
because the
requisite estimates of the underlying fundamentals
are so imprecise.
If policymakers cannot discern a bubble,
then the Standard Policy is the only feasible response.
But
suppose an asset price bubble is identified. Then the
second hurdle is whether bubble
fluctuations have
significant
macroeconomic fallout that monetary policy
cannot readily offset after the fact. Two
situations prevent clearing
this hurdle. First, if the bubble is in
an asset
market that is small in domestic economic
terms—for example,
a localized real estate market—then
a central banker should avoid attempts
at asset price
realignment. Second, even
when there are significant macroeconomic
consequences from an asset price bubble
boom and bust, if
they occur with
a sufficient lag so the policymaker can
adopt a wait-and-see
attitude, then the Standard Policy is again
appropriate. This second case seems relevant
if fluctuations
in the bubble component have only conventional
effects
on aggregate
demand and supply through changes in wealth,
the cost of capital, and balance sheets.
Then, to a
first approximation,
the lags involved in these channels are
about as long as
the lags in the monetary transmission mechanism;
therefore, the Standard Policy should suffice.
For example, fluctuations
in equity prices will affect wealth and
consumer demand, but a nimble central banker
can essentially
offset
these consequences by changing interest
rates in reaction to—that
is, after—the equity price movements.
Alternatively,
asset price movements could have significant
adverse macroeconomic
consequences that are hard
to alleviate after the fact through monetary
policy. The
most often
mentioned possibility is that a bursting
asset price bubble will lead to a broad
financial crisis
and
credit crunch.
Such financial instability is likely
to be transmitted to the economy much more
quickly
than can be
offset by an interest rate policy. This
may set the stage
for invoking
a Bubble Policy. Another possibility
is when the asset price misalignment results
in significant
misallocations of resources, which distort
aggregate demand and
supply
across sectors and over time and impede
the achievement of the highest possible
long-run
economic growth.
For example, the dot-com bubble spurred
overinvestment in fiber optic
cable and decimated the provision of
venture capital
for new technology start-ups for years.
Of course, after the
fact, it is difficult to unwind these
problems with the blunt instrument of monetary policy,
and, depending
on
the specifics, it is possible to conceive
of
a situation in which reducing the bubble
in advance is a preferred
policy strategy.
The final hurdle before
invoking a Bubble Policy involves assessing
whether monetary
policy
is the best way to
deflate the asset price bubble. Ideally,
for the Bubble Policy,
a moderate adjustment of interest rates
could constrain the bubble and greatly
reduce the
risk of severe
future macroeconomic dislocations.
However, bubbles, even
if identified, may not be influenced
in a predictable fashion
by monetary
policy actions. Furthermore, even if
changing interest rates could alter
the bubble path,
such a strategy
may involve substantial costs, including
near-term deviations
from the central bank's macroeconomic
goals as well as potential political
and moral
hazard complications. Finally,
even if monetary policy can affect
the bubble, alternative
strategies to deflate it, such as changes
in financial regulation or supervision,
may be
more
targeted
and have a lower cost.
Conclusion
The
decision tree for choosing a Bubble Policy poses a daunting triple
jump. For example,
consider the
run-up in the stock market in 1999
and 2000, when there was
widespread
suspicion that an equity price
bubble existed and people worried that it
could result
in capital misallocation and financial
instability.
Still,
those worries did
not spur
a Bubble Policy, in large part
because it appeared unlikely that monetary
policy could
have deflated
the
equity price
bubble without substantial costs
to the economy. After the fact, of course,
the
macroeconomic
consequences
from the apparent boom and bust
in equity prices arguably
have been manageable.
However,
the decision tree does not provide a blanket prohibition
on
bubble reduction,
and
as yet, there
is no bottom line
on the appropriate policy response
to asset price bubbles. Those
who oppose a Bubble
Policy stress
the steep informational
prerequisites for success, while
those who favor it note that
policymakers often
must
act on the
basis of incomplete
knowledge. Only further research
and
experience will help settle this
debate, and the two
conference volumes
listed
below provide an introduction
and references to the research literature.
Glenn D. Rudebusch
Senior Vice President and
Associate Director of Research
Further Reading
Asset Price Bubbles: The Implications for
Monetary, Regulatory, and International Policies. 2003.
Edited by William Hunter,
George Kaufman, and Michael Pomerleano. Cambridge, MA:
MIT Press.
Asset Prices and Monetary Policy. 2003. Edited by Anthony
Richards and Tim Robinson. Reserve Bank of Australia.
http://www.rba.gov.au/PublicationsAndResearch/Conferences/2003/index.html
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