The Fed on Asset Bubbles: We Have No Preventative Measures

Preventive medicine may be popular with doctors, but if you're an economist at the Fed, there appears to be no corollary to taking action in an attempt to prevent something bad from happening - at least not when it comes to asset bubbles.

In one more speech by one more Federal Reserve economist on the subject of asset bubbles, we are all reminded that the Fed can not detect an asset bubble in real time.

And even if they could, it is far from certain that they could do anything about it.

In this speech by Frederic S. Mishkin, the newest member of the Fed's Board of Governors, it is explained one more time.

Over the past ten years, we have seen extraordinary run-ups in house prices. From 1996 to the present, nominal house prices in the United States have doubled, rising at a 7-1/4 percent annual rate. Over the past five years, the rise even accelerated to an annual average increase of 8-3/4 percent. This phenomenon has not been restricted to the United States but has occurred around the world. For example, Australia, Denmark, France, Ireland, New Zealand, Spain, Sweden, and the United Kingdom have had even higher rates of house price appreciation in recent years.

Although increases in house price have recently moderated in some countries, they still are very high relative to rents. Furthermore, with the exception of Germany and Japan, the ratios of house prices to disposable income in many countries are greater than what would have been predicted on the basis of their trends. Because prices of homes, like other asset prices, are inherently forward looking, it is extremely hard to say whether they are above their fundamental value. Nevertheless, when asset prices increase explosively, concern always arises that a bubble may be developing and that its bursting might lead to a sharp fall in prices that could severely damage the economy.
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Because central banks are in the business of managing total demand in the economy so as to produce desirable outcomes on inflation and employment, monetary policy should accordingly respond to home prices to the extent that these prices are influencing aggregate demand and resource utilization. The issue of how central banks should respond to house price movements is therefore not whether they should respond at all. Rather, the issue is whether they should respond over and above the response called for in terms of objectives to stabilize inflation and employment over the usual policy time horizon. The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy, as they were in Japan in the 1990s, should the monetary authority try to prick, or at least slow the growth of, developing bubbles?

I view the answer as no.

Of course not.

The entire world economy is predicated on asset prices rising faster than debt - that's how wealth is created these days. And since prices for stocks and real estate don't show up in any of the inflation statistics, in theory, asset prices can (and probably will) go much higher.

Besides, it's no fun being a wet blanket. If you want to be a rock star at the Fed, you can't be a wet blanket.

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets. Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.

A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.
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Many have learned the wrong lesson from the Japanese experience. The problem in Japan was not so much the bursting of the bubble but rather the policies that followed. The problems in Japan's banking sector were not resolved, so they continued to get worse well after the bubble had burst. In addition, with the benefit of hindsight, it seems clear that the Bank of Japan did not ease monetary policy sufficiently or rapidly enough in the aftermath of the crisis.
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A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble. The effect of interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, others suggest that raising interest rates may cause a bubble to burst more severely, thus doing even more damage to the economy. An illustration of the difficulty of knowing the appropriate response to a possible bubble was provided when the Federal Reserve tightened monetary policy before the October 1929 stock market crash because of its concerns about a possible stock market bubble. With hindsight, economists have viewed this monetary policy tightening as a mistake.

Clearly, there are far too many assumptions necessary to even begin to think about targeting asset prices through interest rate policy.

To some degree this makes a lot of sense.

Low interest rates in and of themselves are not necessarily a bad thing - it's when low rates are combined with an abject failure in controlling credit creation and regulating the mortgage lending industry that bad things tend to happen.