Asset bubbles and monetary policy

One of the critical issues during this period of easy money around the globe is whether there are speculative bubbles forming in asset markets and how the central banks will address them. There are two opposite camps. The ECB would be the in the "bubble activist intervention" camp. Watch the markets and take action if the markets move to extremes. The Fed has been in the opposite camp of stating that their role is clearly defined and that stopping speculative bubbles is not one of their priorities.

This has been a recurring topic with little progress in finding ways to address the problem. There still is no clear definition of what it means to say that a market is in a bubble. The US market has recovered handsomely since the lows in March. Is that a bubble. The move has been a clear extreme. The Chinese stock market has increased 90% since its lows, but it is still below former highs. Is that a bubble? Is housing in a region in a bubble? Can sectors of the financial markets be in a bubble?

Those who have studied bubbles have found that they follow a very set pattern, First, there is displacement or a shock to the system. It is a change in the status quo that is not easy to understand or has not been seen often. the The shock leads to a narrative to give a reason for why investors should follow the market. For example, there is a new new thing. There is a productivity shock. There is a change in the oil market.

During this process, there is easy access to cheap credit so that the cost of borrowing is perceived to be much lower then the expected return. The easy credit allows prices to move higher which leads to a positive feedback loop. If there is a shock that is different, it is hard to tie the shock to some valuation. Hence, a positive feedback loop can form. The price rise is consistent with the narrative that is being provided in the market. This would be a period of euphoria which may finally lead to revulsion. the revulsion occurs when credit is not as plentiful or prices do not rise as much as expected. It is harder to push the market higher. There is less momentum so that the story or narrative is questioned.

Notice that the stories that are used to explain the shock must be plausible; therefore, it may be hard to identity the bubble. Those who suggest there is a bubble will be branded as using old thinking or told that this time is different. The pressure to confirm with the positive feedback will be strong, so an idea contrary to this old way of thinking will be hard to present.

The simpler way to stop bubbles is not to allow the situation of free money to exist. if the cosy of borrowing is positive, then there will be a cost with following any narrative that suggests we are moving in one direction.

Should the central bank try and control asset prices? No, the focus should be not allowing excessively easy credit to exist. One measure of the excess credit story will be through following the activity of the asset markets, but there is no good reason to try and determine what bubbles exist and then use the blunt instrument of monetary policy that will affect all market sectors as a way of solving the problem.