Should Central Banks target asset prices?

Robert Shiller's famous historic real dividend chart

One of the most controversial issues in modern macroeconomics is the question whether the central should prick, target, take an interest or ignore asset price bubbles. It is a multi-faceted subject, on which no consensus has yet emerged, which is in part a reflection of much ongoing research in this area. This briefing note is in part related to the briefing note about whether money has a role to play in modern central bank. Some of the arguments are parallels, and pro-bubble-pricking advocates also tend to favour to rely on monetary aggregates, at least to some extent.

Interest in this subject was sparked by the Federal Reserve's monetary policy in the mid-to-late 1990s, a period characterised by Alan Greenspan, former governor of the Fed, as one of "irrational exuberance" as early as 1996. Yet, despite this titulation, Greenspan has been one of the loudest advocates against pricking bubbles, and the monetary policy of the Federal Reserve is largely associated with that position.

There are different strands in the literature. One of the seminal papers in this field is Bernanke and Gertler (1999), on the basis of non-optimising models of monetary policy, where the cofficients of interest rates on inflation and GDP is chosen in an ad-hoc way. Bernanke and Gertler deliberately chose this type of policy to be consistent with real-world central bank behaviour.

The Bernanke and Gertler result is that the central banks should disregard asset prices in their policy formulation. As Adam Posen (2006) has argued: "Central bankers should not try to prick asset price bubbles simply because it is not worth it." In the words of Bernanke and Gertler:

Conditional on a strong policy response to expected inflation, we found little if any additional gains from allowing an independent response of central bank policy to the level of asset prices.  In our view, there are good reasons, outside of our formal model, to worry about attempts by central banks to influence asset prices, including the fact that (as history has shown) the effects of such attempts on market psychology are dangerously unpredictable.  Hence, we concluded that inflation-targeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast.

This is result is challenged among others by two author groups, Stephen Cecchetti, Hans Genberg, John Lipsky, and Sushil Wadhwani (2000),who arrive at different results using an optimizing policy rule but a more restricted set of shocks, while Andrew Filardo (2004) addresses some of the short-coming of either approach with an optimizing general model. He finds that:

The baseline model suggests that central banks should systematically respond to asset price developments generally and asset price bubbles specifically. Indeed, there are good reasons for the central bank to focus only on asset price bubbles, rather than the fundamental component of asset prices, when calibrating its monetary policy response. This general result does not depend on the volatility of asset prices per se or necessarily on the ability to distinguish fundamental movements in asset prices from asset price bubbles.

What all authors agree on is the need for further research is needed on the nature of asset price bubbles, their effect on the economy, and the effect of policy on bubbles.

In another strand of research, Adam Posen looked at the relationship between periods of monetary easing and bubbles, and found the theory that monetary easing would lead to bubbles unsupported. He said in just over one third of instances a period of monetary ease was followed by an asset price boom. He found that property bubbles were normally associated with a period of monetary easing.

He asks:

should central bankers forego monetary easing justified by the usual macroeconomic criteria because of a one-in-three chance that such easing might allow a real estate boom (and a one-in-four chance an equities boom)—especially when equity if not real estate bubbles can arise anyway, even under less than easy monetary conditions? Only if the probability-weighted costs of allowing such a bubble to arise and then burst would be greater than the loss from the foregone monetary ease. If a condition other than monetary loosening itself is what makes a bubble likely or costly, like poor bank capitalization and supervision for example, then the appropriate policy response would be to fix that other condition rather than distorting monetary policy.

A further argument against pricking bubbles, used by Posen, is that monetary policy is too blunt a tool. He said monetary tightening is a highly inefficient tool to prick a bubble, and cites several instances where this has failed. He writes:

Given the well-established fact that central banks today directly influence only a small portion of capital markets with their open market operations and setting of short-term interest rates, and that the primary means of transmitting monetary policy is through expectations, it is difficult to see why there should be a mechanical connection between tighter monetary conditions and investor behavior. If investors truly believe that there is money to be made in a bubble, and usually are counting on making large amounts of money (which is why it is a bubble in the first place), it seems strange to think that a marginal rise in interest rates would be sufficient to alter their actions. If the central bank were truly the only source of liquidity in town, cutting investors off when they had too much credit or were deemed to be taking on too much risk might be effective.

But central banks, and the commercial banks they lend to, are not investors’ only source of liquidity. Just as drunkards or gambling addicts who have less money will forego basic needs or sell personal items to continue their binges, investors who wish to ride a boom upward will sell or mortgage safer assets to do so, or they will look abroad for credit, as necessary. If investors believe in supra-normal market returns being available to them, a mere rise in short-term interest rates will only tell them they need to invest more.

Nouriel Roubini counters Posen’s arguments that only one third of monetary easing periods resulted in a bubble by retorting that this was to be expected, since monetary easing’s usually accompany recessions, and one would not necessarily expect a bubble to grow out of that. He argues that:

the issue is not whether easy money causes a bubble, as sometimes, bubbles can be triggered by financial rather than monetary factors. The relevant issue is whether, whatever the bubbles are caused by, monetary policy should react to a bubble.

He also criticized the Federal Reserve’s asymmetric response to bubbles, which consists of not reacting during a bubble, but to ease monetary policy aggressively after the bubble has burst (“mop up after” in Fed jargon). Posen and others have retorted that asymmetry is inherent in economics, for example, monetary policy is less effective when interest rates are close to zero. Summing up, Roubini presents the following six arguments in support of his claim that central bank should prick asset price bubbles.

1. Analytical models suggest that optimal monetary policy rules imply targeting of asset prices on top of inflation and growth in the monetary policy reaction function.

2. Optimal monetary policy should react to asset prices even when there is uncertainty about the existence and extent of an asset bubble.

3. Uncertainty as to whether bubbles affect the economy does not reverse the result that monetary policy should react to asset bubbles.

4. Monetary authorities should attempt to carefully “prick” a bubble.

5. A monetary policy that reacts to asset bubbles does not need to lead to severe economic contraction. It may instead appropriately control a bubble that may become damaging if left to grow without control.

6. It is inconsistent and non-optimal to argue that monetary policy should react to bursting bubbles but not to rising bubbles.

This is one of those unsettled economic debates, which is lively to be active in the next few years. the further development of this debate will depend partially on further economic research in bubbles and their relationship to the economy and economic policy, as well as actual events. It is too early yet for a definitive assessment of the non-bubble-bursting Greenspan years at the Fed, and the judgement whether he was right not to prick the dotcom bubble earlier will depend greatly on how the US and world economies adjust to the imbalances that have been caused by this policy.