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Asset Price Bubbles and Monetary Policy- Robin Trehan

Is it possible to create a monetary policy that successfully eliminates asset price bubbles? Some experts feel that this idea is “all hat and no cattle”. It sounds good but is unlikely to work in the real world. Even if it were feasible, it would weaken the free-market system.

 

Asset price bubbles – or “boom and bust” cycles, as they are sometimes known – can be hard to anticipate or identify early on. It would be extremely difficult to recognize a bubble before it occurred and take appropriate action quickly enough to head it off. It would be a case of “closing the barn door after the horse has run away”.

 

Some argue that there are various types of data, such as price-return ratios, that could possibly provide the needed information in time. But these indicators are by no means reliable proof of overvaluation. There are just too many variables involved and the margin for error is simply too big.

 

This is not the only drawback of attempting to avert asset price bubbles using monetary policy. Even if such bubbles could be adequately identified in time, raising interest rates or taking other actions to try and head them off would be a case of “using an elephant gun to kill a mouse”. The bubble would typically, although not always, be confined to a specific sector. For example, in the late 1990’s tech stocks experienced a bubble.

 

It is impossible to execute monetary policy in a vacuum. Clearly, any action taken to thwart a bubble in a certain sector is going to impact the economy as a whole. Such an impact could easily throw off the natural balance of the markets and even result in a depression.

 

Monetary policy can be a good tool for dealing with asset price bubbles, but not for preventing them completely. Occasional asset price bubbles are a natural features of a free-market economy. Monetary policy should focus on keeping the economy healthy so as to minimize their negative effects and reduce their occurrence. Unnatural interference with the markets is not the answer. The right approach is “playing to the strengths” of both monetary policy and the natural market function.

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