Dudley, William

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.