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.

I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

That said, there is some evidence that a tighter monetary policy will reduce desired leverage in the financial system by flattening the yield curve and reducing the profitability of maturity transformation activities.¹² To the extent this is true, that may imply a somewhat more favorable trade-off in “leaning against” a bubble. More research is needed on this subject. For now at least, monetary policy appears to be inferior to macroprudential tools that seek either to limit the size of prospective bubbles or to strengthen the financial system so that it is more resilient when asset prices fall sharply.

One type of cost arises because monetary policy is a blunt instrument...

We simply do not have good theories or empirical evidence to guide policymakers in using short-term interest rates to limit financial speculation. Given our current state of knowledge, my preference at this time would be to use regulation and supervision to strengthen the financial system and lean against developing problems. Monetary policy would be used only if imbalances were building and regulatory policies either were unavailable or had proven ineffective. The homework assignment is to improve our ability to identify incipient financial imbalances and understand their interactions with changes in policy interest rates.

Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis.

My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak...

Is there any role for monetary policy in addressing bubbles? Economists have pointed out the practical problems with using monetary policy to pop asset price bubbles, and many of these were illustrated by the recent episode. Although the house price bubble appears obvious in retrospect--all bubbles appear obvious in retrospect--in its earlier stages, economists differed considerably about whether the increase in house prices was sustainable; or, if it was a bubble, whether the bubble was national or confined to a few local markets. Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established.

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach...

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

While recent events have indeed imposed significant costs on society, I fear that monetary policy tools may be too blunt for such a fine-tuning policy.⁵ Central bankers have imperfect information, and for many asset classes, sudden price declines may have minimal impact on the real economy.⁶ So, my concern is that using monetary policy to "lean against bubbles" could end up causing more harm to the economy than good.

See Dudley's comments on asset price targeting.

In my view, asset prices should play a greater role in policy deliberations and decisions than currently is the case…in view of the damage resulting from the decline in housing values, as well as the aftermath of the collapse of prices of technology stocks earlier this decade, I think it essential to revisit these issues.

In my opinion, this crisis should lead to a critical reevaluation of the view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst.

[I]f a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy.5 However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets.6 Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.