Since the boom and bust in technology stock prices around the turn of the century, there has been growing debate about the role of asset prices in the conduct of monetary policy. This debate has become even more salient in the wake of the recent boom and bust in the US housing market and subsequent global financial crisis. The consensus among policymakers has been that while monetary policy should take account of the implications of developments in asset prices for the broader economy, monetary policy should not seek to actively manage or explicitly target asset prices as such. Former US Federal Reserve Chairman Alan Greenspan was particularly prominent in defending this view, a position widely held within the central banking community, at least until recently.
There has nonetheless been a dissenting view among some policymakers, academics and commentators that monetary policy should aim to prevent pronounced asset price cycles as part of a broader mandate to promote financial and macroeconomic stability. While there is little support for targeting specific values or growth rates for asset prices, there is growing support for the idea that monetary policy should lean more heavily against incipient asset price inflation, rather than merely responding to the macroeconomic consequences of asset price busts. There are now indications of a shift in sentiment at the Federal Reserve (the Fed), the Reserve Bank of Australia (RBA), and other central banks in favour of a more activist role for monetary policy in relation to asset prices.
This monograph argues that monetary policy should not aim to actively manage asset price cycles. It begins by considering the consensus view of the relationship between monetary policy and asset prices and the evolving challenge to this view in light of the recent global financial crisis.
The idea of ‘bubbles’ in asset prices is then considered. It is argued that a ‘bubble’ is not a meaningful way to characterise asset price cycles because the concept lacks both analytical coherence and empirical support. Some of the most well-known historical ‘bubble’ episodes, such as the Dutch ‘tulipmania’ of the 1630s, are shown to be myths that have been largely debunked by modern scholarship. The inability of economists to give substance to the idea of ‘bubbles’ argues against using monetary policy to manage asset price cycles.
The monograph reviews two recent ‘bubble’ episodes: the turn of the century boom and bust in technology stocks; and the more recent US housing cycle. It questions whether either episode can be meaningfully characterised as a ‘bubble’ and argues that monetary policy played only a minor role in both episodes.
The monograph considers some of the practical problems that are likely to be encountered in implementing an activist approach to asset prices. These difficulties help explain why historical attempts to prick asset price ‘bubbles’ have often ended in disaster. Fixed or managed exchange rate regimes represent the most direct attempt by central banks to manage asset prices and have been a notable failure historically.
Asset price booms and busts have been experienced in the context of a broad-range of monetary policy regimes and in both high and low inflation environments. This suggests that there is not a straightforward relationship between monetary policy and asset prices that can be relied upon for policy purposes. Asset price booms and busts are more likely to emerge when monetary policy departs from established benchmarks focused on the stability of consumer prices, implying that monetary policy should be more rule-bound rather than more activist or discretionary.
Asset price cycles are a normal part of the functioning of financial markets and may have significant economic benefits. These cycles are generally only harmful when associated with poorly regulated financial systems and government incentives to risk taking. Policymakers need to focus on better prudential regulations rather than monetary policy as the best defence against potentially adverse interactions between asset price cycles, the financial system, and the broader economy. The paper concludes by suggesting that the growing debate over the relationship between monetary policy and asset prices has parallels with the ‘socialist calculation debate’ of the 1920s.
Stephen Kirchner is a research fellow with the Economics Program at the Centre for Independent Studies. Previously, he was an economist with Action Economics LLC, and director of economic research with Standard & Poor’s Institutional Market Services, based in Sydney and Singapore. He has also worked as an adviser to members of the Australian House of Representatives and Senate.
Dr Kirchner has lectured in economics at the University of New South Wales, Macquarie University, and the University of Technology, Sydney. He has a BA (Hons) from the Australian National University, a Master of Economics (Hons) from Macquarie University, and a PhD in economics from the University of New South Wales.
