"Bubble, Bubble, Toil and Trouble: A Dangerous Brew for Monetary Policy"

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Sound policymaking requires us to understand the limits of what we know. I doubt we could find enough agreement among policymakers or economists about the interpretation of asset-price movements to allow for stable, rule-based policymaking. In the absence of such a clearly stated rule, we risk uncertainty about central bank policy itself as well as its effect on the economy... Humility in policymaking requires that we respect the limits of our knowledge and not overreach, particularly when it involves over-riding market signals with policy actions.

Another challenge in addressing asset-price bubbles in practice is that contrary to many economic models, in reality there are many assets, not just one. And these assets have different characteristics. For example, equities are very different from homes. Misalignments or bubble-like behavior may appear in one asset class and not in others. But monetary policy is a blunt instrument. How would monetary policy go about pricking a bubble in technology stocks in 1998 and 1999 without wreaking havoc on investments underlying other asset classes?

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Indeed, I believe that we are discussing the question of asset prices and monetary policy today, at least in part, because Fed policy during mid-2000s “went off track.” John Taylor has argued forcefully that the Fed kept interest rates too low for too long from 2003 to 2005. As an erstwhile member of the Shadow Open Market Committee, I stood in this very room in 2003 and 2004, expressing concerns that the fears of deflation were excessive and that policy was probably too accommodative. The error may not have been that policymakers failed to pay attention to the fast upward rise in asset prices, but that they deviated from a systematic approach to setting nominal interests.

It is also possible to overreact, shutting down a particular financial market practice which in reality does not pose a systemic risk. During the technology boom of the 1990s, many argued that a bubble had formed and that policymakers should address the bubble with appropriate action. Still, I think few would now argue that we would have wished to miss out on the technology boom of the 1990s. Closing off those developments through aggressive policy might have deprived the economy of important advances in productivity.

Despite the fact that it is hard to discern bubbles, especially in their early stages, I conclude that uncertainty is not grounds for inaction. Instead, the decision whether to act depends on whether appropriate tools can be deployed to limit the size of a bubble and whether the benefits of acting and deploying such tools are likely to exceed the costs.

That cost-benefit calculus, in turn, depends crucially on the tools we can deploy to limit the growth of bubbles and the consequences when they burst. In this respect, I will argue that, in most cases, use of the bully pulpit and macroprudential tools, such as rules limiting loan-to-value ratios or leverage, are likely to prove superior to monetary policy.

Turning to the first issue, identifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles—especially credit asset bubbles—may be less daunting. To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable...

Turning to the second issue of how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process...

Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.¹

Whether it would be more effective to limit leverage directly by regulatory and supervisory means or via monetary policy is still an open question. But it is becoming increasingly clear that a totally hands off approach is problematic.

This raises the broader—and very contentious—issue of whether monetary policy should seek to lean against potentially dangerous swings in asset prices. The answer is far from clear, because the use of monetary policy for these ends necessarily compromises the attainment of other macroeconomic goals. Because such use of monetary policy is costly, high priority should be assigned to developing regulatory tools to address systemic risk. Even so, the crisis of the past two years has prompted many of us to reexamine the widely held view that monetary policy should respond to asset prices only to the extent that they influence the anticipated trajectories of inflation and unemployment.  Further research into the connections among monetary policy, the banking and financial sectors, and systemic risk is needed to help answer this question.11

When the monetary authorities judge that important asset prices or rates of credit expansion are deviating from sustainable long-run trends, should they adjust their policy setting to damp those price and credit movements--beyond whatever actions might be called for to preserve macroeconomic stability over the usual two- to three-year planning horizon for monetary policy?

To preview, I don't think we know enough to answer those questions with any confidence--to judge whether the benefits of such extra action would outweigh the costs...

The difficulties I've just outlined lead me to a strong preference for using prudential regulation to deal with potential problems in credit and asset markets. Historically, bank supervision has been focused on individual institutions rather than on the system as a whole. Unfortunately, such microprudential regulation in practice was not as effective as it should have been, and an important challenge for policymakers will be to strengthen the supervision of individual institutions. However, the experience of this crisis also strongly suggests that policymakers need to pay close attention to developments across the financial system--that is, to engage in macroprudential supervision and regulation. Both microprudential and macroprudential oversight are essential to making the financial system more resilient to the inevitable cycles in asset prices, and less prone to large cycles.

In sum, it seems to me that under most circumstances monetary policy is not the appropriate tool to use to address asset-price developments or growing vulnerabilities in financial markets. As I argued earlier, microprudential and macroprudential policies seem likely to me to be more effective and targeted at the problem than monetary policy adjustments, and in my view these tools should be the first that policymakers deploy.

I agree that the severity of the recent crisis argues against simply waiting and mopping up after the fact if and when the prices of some assets do collapse. But the type of proactive response by a central bank that I envision is not well captured by the expression "leaning against a bubble." I prefer to see policy reacting to apparent exuberance in asset markets and the problematic risk exposure this could create, rather than initiating action out of a strong conviction that these particular assets are overvalued. In addition, the expression "leaning against a bubble" evokes polices that are aimed at achieving some targeted decline in asset prices. In contrast, I view the goal of intervention as insuring that exuberance in asset markets does not ultimately threaten the financial system or contribute to financial distress.

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At this point, I think that regulatory policy provides the most promise. For one, it is important to improve resolution procedures for financial institutions in the event of insolvency...

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At the same time, maintaining financial stability is also likely to involve more-proactive ...  policies that vary with economic conditions. For example, when faced by several indications that asset markets may be exuberant, we might consider increasing capital requirements...

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I should note that some policymakers have recently expressed openness to the notion of leaning against bubbles. The proposals I just outlined are not out of scope with some of their thinking. This is because they, too, often give regulatory policy a prominent role

Asked about record gold prices and the decline of the dollar, Plosser said "I think we don't want to entirely dismiss that... I do think from a policy standpoint that we need to be cognizant of what these asset markets are doing and.. better understand how they may or may not be giving us clues about what the future may hold."

In the simplified world of an introductory economics class, a market brings together the potential buyers and sellers of a product to negotiate prices and quantities... While this stripped-down story is remarkably powerful in its essential predictions about the behavior of markets and economic agents, it leaves the operation of the market itself as a mystery.  Any real-world market must deal with at least two fundamental questions:  first, how do the buyers and sellers find one another?  And second, how can buyers be assured that sellers will deliver as promised, and that the goods will be of the quality and value that the buyer expects?  To understand how markets deal with the fundamental issues of transaction costs and information costs is an important and enduring challenge for economists.

Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

This dynamic poses a number of risks to the functioning of the financial system. It reduces the effectiveness of monetary policy, as the widening in spreads and risk premia worked to offset part of the reduction in the fed funds rate. Contagion spreads, transmitting waves of distress to other markets ...

The most important risk is systemic: if this dynamic continues unabated, the result would be a greater probability of widespread insolvencies, severe and protracted damage to the financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it is not something that the market can solve on its own. It carries the risk of significant damage to economic activity. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings and rising unemployment.

[It is a] very difficult policy to intervene in the workings of markets at a particular chosen time.

It's difficult to identify, it's difficult to choose timing, difficult to be sure that market forces themselves will not have what
turns out at the end to be a positive effect.

From audience Q&A, as reported by Market News International, saying he's not "comfortable" with the Fed pre-emptively targeting asset bubbles.

While I have not yet changed my opinion that asset-price levels should not be an objective of monetary policy, I am reviewing this conclusion in the wake of the fallout from the decline in house prices and from the earlier collapse of prices of technology stocks. To be sure, it is challenging at best to identify when asset prices have reached excessive levels, to build support for action once identification has occurred, and to implement corrective policy successfully. These are all significant obstacles, and thus it may well be that containing damage as and after prices correct is, in the end, the preferable alternative.

However, I think it is important to consider these conclusions in light of recent events, where it has proven to be neither easy nor costless to deal with the aftermath of unsustainably high asset prices.

[S]trains in financial markets can spill over to the broader economy and have adverse consequences on output and employment. Furthermore, an economic downturn tends to generate even greater uncertainty about asset values, which could initiate an adverse feedback loop in which the financial disruption restrains economic activity; such a situation could lead to greater uncertainty and increased financial disruption, causing a further deterioration in macroeconomic activity, and so on. In the academic literature, this phenomenon is generally referred to as the financial accelerator (Bernanke and Gertler, 1989; Bernanke, Gertler, and Gilchrist, 1996, 1999).

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.