by Calculated Risk on 8/11/2005 11:14:00 AM

The Federal Reserve's Glenn D. Rudebusch, Senior Vice President and Associate Director of Research has released an economic letter: 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.

Click on Chart for larger image.

A decision tree for choosing between the Standard and Bubble Policies is shown ... 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 ...
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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.

The problem is each of these hurdles is difficult to negotiate. Rudebusch concludes:

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.

My view is regulatory substitutes are the answer, not monetary policy. For the housing bubble, more stringent lending requirements and oversight probably would have prevented much of the speculation.