Should Monetary Policy Prevent Bubbles?*
Remarks by Charles L. Evans
President and Chief Executive Officer
Federal Reserve Bank of Chicago
Conference Banque de France - Federal Reserve Bank of Chicago
"Asset Price Bubbles and Monetary Policy"
I would like to thank Deputy Governor Jean Pierre Landau, Benoit Mojon, and the Banque de France for organizing this timely conference on asset price bubbles and monetary policy. And I would like to thank two of our Chicago Fed staffers—Jonas Fisher and Gadi Barlevy—who helped Benoit put together such an interesting program. It's been a pleasure for me to be in the audience, and now, I will share my thoughts with you on this important topic.
Let me emphasize that the views that I am presenting today are my own and not necessarily those of the Federal Open Market Committee or my other colleagues in the Federal Reserve System.
The financial crisis we have experienced during the past two years has challenged the conventional view on how monetary policy should respond to asset price movements. Before the crisis, the common view was that a central bank should not react to asset price movements, except to the extent that they affect forecasts for inflation and the output gap. A central bank would instead stand ready to respond if and when a collapse in the prices of some assets threatened its ability to meet its policy mandates. Now, in the aftermath of the crisis, there are increasing calls for central banks to be more proactive in responding to signs that an asset bubble may have emerged. This notion is often described as an imperative to "lean against a bubble," meaning that the central bank should act to lower asset prices that, by historical standards, seem unusually high.
Today, I would like to offer my position on this question. 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.
Let me elaborate. This will help explain why the conventional view of how policy ought to respond to bubbles has changed in the wake of the financial crisis. The original case for why central banks should not respond to bubbles relies on two arguments. The first holds that it is virtually impossible to determine whether an asset is trading above its fundamental value, certainly not in real time and often not even after the fact. The second argument holds that monetary policy as a tool is too blunt to prick bubbles effectively. This is because monetary policy cannot be targeted precisely, and will affect other financial and macroeconomic variables beyond just the set of asset prices in question. In addition, the typical changes in interest rates that a central bank might contemplate are likely to be too small to produce big changes in asset prices.
Does the recent crisis justify revising this view? On the one hand, the crisis has certainly taught us a great deal about asset price booms and busts. We've learned, for example, that we must be attuned to the warning signs that might indicate potential dangers in housing markets. But does this mean we should be more confident in our ability to easily and definitively sort out in real time whether a rapid increase in asset prices is associated with overvaluation? I am skeptical. Each new episode is likely to involve its own idiosyncratic features—enough to bring a new chorus proclaiming that "this time [it] is different" and arguing that we are not in fact facing a bubble. As Carmen Reinhart and Ken Rogoff remind us in their recent book, this pattern has been going on for at least eight centuries. As for the bluntness of monetary policy tools, I don't think the crisis has demonstrated that the typical levers of monetary policy are any less blunt than we used to think.
Instead, it seems it is the severity of the crisis, and the desire to not let one like it reoccur, that has encouraged people to contemplate alternative policy responses. Certainly, the crisis ought to have sobered us to the thought that asset price collapses are always sufficiently manageable after the fact. But if the ultimate desire is to reduce the likelihood of such crises, our policy response should focus on achieving financial stability rather than on identifying and purging asset bubbles per se. An appropriate policy response may entail responding to bubbles, but I would argue that this should only be a means to achieving the broader goal of financial stability, rather than an end in and of itself. Indeed, I am concerned that some policies may not receive enough attention if we frame the lessons from the recent crisis too narrowly in terms of leaning against a bubble.
So what steps should we take to reduce the chances of another financial crisis? Part of the answer lies in structural prescriptions. The formulation of such frameworks will not be easy, and would greatly benefit from further research on how financial markets interact with real economic activity. Researchers in both macroeconomics and finance have a good deal of work to do on this score. But I am hopeful that this research can help identify which environments might best reduce the chance that financial markets trigger ruinous crises, as well as determine what policy instruments we should add to our toolkit.
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. This includes requiring firms to formulate contingency plans that would be used in the event of their failure. Doing so should reduce the chances that the collapse of a particular institution will threaten the broader financial system. Just as importantly, these plans also would improve discussions between supervisors and institutions. This would facilitate horizontal reviews and in so doing help first identify and then reduce potential systemic risk exposures.
At the same time, maintaining financial stability is also likely to involve more-proactive, state-contingent measures, that is, 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. This might be either for financial institutions as a whole or for specific institutions that choose to hold assets for which there is concern of a price collapse. These requirements should serve as a cushion if purchases of these assets result in losses. They may also end up putting downward pressure on asset prices and, at some point, even eliminate speculative excesses. Here I have in mind theories of bubbles that are due to so-called agency problems, where those who trade assets are acting as agents on behalf of others and cannot be perfectly monitored. These models, such as the models in the papers presented at the conference by Gadi Barlevy and Xavier Ragot, suggest that forcing agents to stake more of their own resources could provide a strong disincentive for market participants to purchase overvalued assets, possibly deflating a bubble that has already emerged.
That said, it is important to stress that lowering asset prices would not be the direct intent of these policies and, therefore, not the way we should judge their success. We should consider an intervention successful if it helps to safeguard financial institutions and the real economy in the event that asset prices collapse, not if it manages to lower asset prices to better reflect the true worth of the underlying assets. In fact, we are unlikely to ever know if we accomplished the latter.
One advantage of using financial stability as our metric is that it does not require a central bank to take a stand on whether the assets in question are overvalued. Rather, the responses would be implemented whenever there are concerns that asset prices may experience a sharp decline in the future, regardless of whether this decline is driven by fundamentals or by the bursting of an asset bubble.
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. Thus, while I might motivate and describe the appropriate policy response somewhat differently, my recommendation does not represent a radical departure from what others have argued.
In closing, let me return to the broader themes of the conference. In the past, economists used to debate whether bubbles were even possible. The research discussed here shows that there are conditions under which bubbles can unequivocally occur, even among fully rational market participants, and that in some cases it might be desirable to burst them. But what these papers do not show is how central banks can reliably identify bubbles. The best they can offer are useful warning signs, such as those in the paper that Carsten Detken will present tomorrow. As long as we can't detect bubbles with great confidence, it seems unwise to adopt fighting them as a policy objective, even if only sparingly. Instead, it seems better to commit to what central banks are already mandated to do: preserve the safety and soundness of the financial system at all times, including when there is apparent exuberance in asset markets.
*The views expressed here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.
I would like to acknowledge the help of the following Chicago Fed staff in preparing these remarks: Dan Sullivan, Spencer Krane, and Gadi Barlevy.
For example, in Peter M. Garber, 2000, Famous First Bubbles: The Fundamentals of Early Manias, Cambridge, MA: MIT Press, the author revisits three historical episodes that are commonly described as bubbles. Garber concludes that in all three, price movements can be explained by changes in the expectations of fundamentals by market participants. Ellen McGrattan and Edward Prescott similarly argue that the rise in the stock market prior to the 1929 crash was not a bubble; see Ellen McGrattan and Edward Prescott, 2003, "Testing for stock market overvaluation/undervaluation," in Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies, William C. Hunter, George G. Kaufman, and Michael Pomerleano (eds.), Cambridge, MA: MIT Press, pp. 271–276.(return)
The notion of a policy being too blunt because it can affect many variables in addition to asset prices is usually attributed to Bernanke and Gertler; see Ben Bernanke and Mark Gertler, 1999, "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter, pp. 17–51. The notion of a policy being too blunt because it is ineffective has been raised by Greenspan; see Alan Greenspan, 2002, "Central bank perspectives on stabilization policy—Articles from the bank's Economic Policy Symposium, ‘Rethinking Stabilization Policy,’" Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter, pp. 5–12. See also Frederic S. Mishkin, 2008, "How should we respond to asset price bubbles?," speech at the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, Philadelphia, May 15.(return)
In a November 2008 speech, Don Kohn offers an insightful discussion of how his view of asset bubbles was informed by the crisis, including whether we can have advance warning that certain markets are subject to bubbles before the prices of these assets decline; see Donald L. Kohn, 2008, "Monetary policy and asset prices revisited," speech at the Cato Institute's 26th Annual Monetary Policy Conference, Washington, DC, November 19.(return)
Carmen M. Reinhart and Kenneth S. Rogoff, 2009, This Time Is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press. Reinhart and Rogoff go on to argue that since these episodes are so similar, contrarian claims should be refutable with evidence from various advance indicators of such crises. By contrast, Caballero and Kurlat argue that crises are nearly impossible to predict; see Ricardo J. Caballero and Pablo Kurlat, 2009, "The ‘surprising’ origin and nature of financial crises: A macroeconomic policy proposal," paper at the Economic Policy Symposium, Financial Stability and Macroeconomic Policy, Jackson Hole, WY, August 20–22, available at www.kc.frb.org/publicat/sympos/2009/papers/caballeroKurlat.08.24.09.pdf. This debate underscores the point I wish to make: that making the case that we are facing a bubble is likely to be difficult, since it will always be possible to argue about the relevance of indicators that predicted crises in the past.(return)
Gadi Barlevy, 2009, "A leverage–based model of speculative bubbles," paper at Banque de France and Federal Reserve Bank of Chicago conference, Asset Price Bubbles and Monetary Policy, Paris, November 13; and Simon Dubecq, Benoit Mojon, and Xavier Ragot, 2009, "Risk shifting, fuzzy capital requirements and the build up of financial fragility," paper at Banque de France and Federal Reserve Bank of Chicago conference, Asset Price Bubbles and Monetary Policy, Paris, November 13. The original work on bubbles and agency problems was done by Franklin Allen and Gary Gorton, 1993, "Churning bubbles," Review of Economic Studies, Vol. 60, No. 4, pp. 813–836, and Franklin Allen and Douglas Gale, 2000, "Bubbles and crises," Economic Journal, Vol. 110, No. 460, pp 236–255; however, they do not emphasize the role of capital requirements in avoiding bubbles in these papers.(return)
See William Dudley 2009, "Lessons learned from the financial crisis," remarks at the Eighth Annual BIS conference, Basel, Switzerland; Gary H. Stern, 2009, remarks to the Helena business leaders, Helena, MT, July 9; Janet L. Yellen 2009, panel discussion for the Federal Reserve Board/Journal of Money, Credit, and Banking,(JMCB) conference, Financial Markets and Monetary Policy, Washington, DC, June 5; and Janet L. Yellen, 2009, "A Minsky meltdown: Lessons for central bankers," speech at the 18th annual Hyman P. Minsky Conference on the State of the U.S. and World Economies, Meeting the Challenges of the Financial Crisis, Levy Economics Institute of Bard College, New York City, April 16.(return)
Lucia Alessi and Carsten Detken, 2009, Real Time Early Warning Indicators for Boom–Bust Asset Price Cycles, paper at Banque de France and Federal Reserve Bank of Chicago conference, Asset Price Bubbles and Monetary Policy, Paris, November 14.(return)