Personal Perspective on the Central Bank Intervention Regarding Asset Bubbles

Bernanke and Gertler (2000) categorise bubbles as episodes that are difficult or impossible to identify even after the fact. They warn that there is no form of monetary policy that can be used to safely pop a bubble and that any steep action taken by central banks would threaten the welfare of the economy far greater than the act of neglect. The general consensus among Central banks before the 2008 crisis is that enforcing monetary policy should only aim to control inflation and to a lesser extent, stabilize the output gap. In this paper I will analyse the argument for central banks to take a more proactive approach in targeting asset bubbles by incorporating asset prices into their policies as well as analysing a range of different bank intervention strategies.

Howard Davies (2009) identifies two major improvements that central should incorporate to further their involvement in the deflation and prevention of asset bubbles. Firstly, Central Banks should take an active approach to incorporating asset prices as a major factor when considering inflation target rates. Secondly, in the face of price misalignments, Interest rates should be adjusted accordingly to moderate credit expansion and bring forward the correct pricing adjustments. Howard refutes the excuse of the inability to identify bubbles pre-emptively, to warrant inactivity from central banks, arguing that similar to interest rates and other aspects of monetary policy, the assessment of bubbles is not expected to be based off an exact science. Banks should instead use the assessment of risk and other indicators to identify potential asset bubbles.

Howard explains with reference to the early 2000s and the housing crisis, that lowering interest rates are the direct cause of credit expansion, leading asset prices to inflate and subsequently financial markets to crash. Howard proposes that instead of drastically increasing interest rates that would subsequently slow the whole economy, perhaps a more productive effort would be to gently slow the trend of diminishing interest rates, “a gentle tilt against the wind” as he described. Howard also believed that a more active effort should be made to try and find and use other mechanisms to moderate credit and asset price expansion.

John Conlon (2014) takes a more conservative perspective. He believes the decision on whether central banks should intervene with “anti-bubble” policy should be dependant on the information asymmetry between the bank and private investors. In order to determine this, Conlon explains that banks must analyse the data sources from the private sector and compare it with their own information. From this, the central bank should only proceed to take policy action if they believe they have an informational advantage. He also warns that central bank intervention will set a precedent that will influence future investment decisions made by private investors. He explains that if bank intervention on asset pricing is normalised, then the case of no anti-bubble policy announcements will be used by investors as a strong indicator to further increase the price of the asset and thus further exacerbate the size of the bubble.

Gwilym (2013) wrote an article explaining that it will be more beneficiary in terms of welfare for monetary policy to target the deviations in asset price rather than to target the components that lead to the mispricing of the asset. Gwilym highlights that the behavioural dynamics of a bubble are too complex for Central Banks to understand, making it near impossible to measure the fundamental value of assets, and because of this targeting mispricing will be entirely unproductive. Gwilym analyses the “leaning against the wind” approach, establishing that although this reaction will reduce the efficiency reactions to changes in fundamental prices, the reduction of behavioural biases as a cause of this will outweigh the negative impacts. However, Gwilym bases his assumptions on the behavioural finance model in which agents base their projections for future asset prices simply off hysteric rules alone, and thus fails to entirely depict real-world markets and their reactions realistically.

Jordi Gali (2014) opposes the “Leaning against the wind” approach, explaining in his article, that raising interest rates to deflate a growing bubble, can potentially raise the price volatility of assets in a bubble. Gali points out that when the central bank influences real interest rates, they also affect real asset prices, and in doing so, modify the distribution of consumption. He instead promotes policies that aims to strike a balance between stabilization and current aggregate demand. Gali’s model demonstrates that given the bubble is large enough, an appropriate response would be to lower interest rates, a reverse approach to leaning against the wind. It is important to point out, however, that Gali’s model is based off a “rational bubble”, consisting of a market place with entirely rational agents, no explicit financial sector as well as no other market imperfections, and thus fails to depict asset price deviations from fundamental in accordance to actual economies.

Vandana Singhvi Patel (2010) examines the reaction function imposed by Central banks in response to potential asset bubbles, paying attention to the United States Federal Reserve (FED). In his article Patel responds to the self-correcting market assumption that implies that bubbles simply do not exist, this is based off the belief that even if assets deviate from their fundamental value, rational investors would take opposing positions causing asset prices to level to their correct equilibrium. This stance refutes the idea that banks should intervene before the bubble burst since it would imply that markets are wrong, and banks are privy to better information. Patel counters this, with a similar viewpoint to Davies (2009), stating that banks always make decisions with some level of uncertainty and poor data.

Patel further imposes the importance of pre-emptive intervention by demonstrating the large implications that natural asset bubbles bursts can have on the real economy, explaining that inflammations in asset prices will likely cause the wealth effect. In this case, the rise in asset prices will artificially increase individual portfolios in terms of equity and assets, encouraging higher spending and thus boosting aggregate demand. But once the bubble pops, the realisation of their shrunken asset portfolios aggressively reduces their purchasing power causing the entire economy to contract. Patel uses this to argue that taking precautionary measures to deflate potential bubbles will be more beneficial for the economy than allowing them to naturally burst. Patel also evaluates the FED’s position through the dual mandate that was adopted in 1977. He explains that although Central banks have taken the right direction in terms of increased transparency, the current objectives only concentrate on long term interest rates, the consequence of which is affected by employment and price stability. Under this notion, the FED will only impose anti-bubble policies if the bubble itself exerts inflationary pressures, however, if the asset price movements do not affect general prices then the FED will fail to act until after the bubble bursts.

The aftermath of a bubble burst will then initiate the FED to examine the effects on growth, employment and price targets to determine its course of action, which historically has consisted of expansionary monetary policy. Patel extensively critiques this approach, referring to it as a “mopping up strategy”. He first explains that because this strategy requires the FED to analyse the macroeconomic effects, it will cause a lag in response. Furthermore, an expansionary monetary policy which is heavily reliant on lowering interest rates may not be feasible as the interest rates may already be too low. On top of this, keeping interest rates low for too long increases the economy’s susceptibility to other asset bubbles. Finally, Patel highlights the issue of moral hazard, as setting the precedent that Banks will not interfere with asset markets or bubbles and instead provide a safety net for investors to lessen their losses, will encourage investors to take on higher-risk investments moving forward.

To conclude, it is evident that a major concern with pre-emptive bank intervention is whether banks possess enough information to act appropriately. I believe Davies and Patel correctly point out that this alone should not restrict banks from enforcing “anti-bubble” policies as it similarly does not restrict them from enforcing inflation rate policies. I also think Conlon adds a valuable improvement that could be made to this, by calling for banks to seek out data sources that could be used by private investors to understand their own informational capacity. I agree with Patel’s recommendation for banks to enforce asset pricing and monetary policy prior to bubble bursts, as he convincingly highlights the moral hazard issues, limiting expansionary influence and severe purchasing repercussions faced by economies in the case of reactionary policies.