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Governor Frederic S. Mishkin
At the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, Philadelphia, Pennsylvania
May 15, 2008
How Should We Respond to Asset Price Bubbles?
In my remarks today, I would like to return to the issue of how we should respond to possible asset price bubbles.1 I will first focus on the conceptual framework I use to evaluate these issues, based on a core set of scientific principles for monetary policy.2 My framing of the issues highlights the following three questions:
[..]
Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices.4 The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.
At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The decline in lending depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets.5 In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.6
[..]
The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.7
[..]
After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative.8 As I pointed out in a paper that I presented at the Federal Reserve Bank of Kansas City's Jackson Hole conference in September, if monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small.9 More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.
To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.
[..]
Second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, raising interest rates may be very ineffective in restraining the bubble, because market participants expect such high rates of return from buying bubble-driven assets.12 Other research and historical examples (which I will discuss later) have suggested that raising interest rates may cause a bubble to burst more severely, thereby increasing the damage to the economy.13 Another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions. The bottom line is that we do not know the effects of monetary policy actions on asset price bubbles.
[..]
I would like to emphasize the importance of regulatory policy. Monetary policy--that is, the setting of overnight interest rates--is already challenged by the task of managing both price stability and maximum sustainable employment. As a result, it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices.
Of course, some aspects of such policies are simply the usual elements of a well-functioning prudential regulatory and supervisory system. These elements include adequate disclosure and capital requirements, prompt corrective action, careful monitoring of an institution's risk-management procedures, close supervision of financial institutions to enforce compliance with regulations, and sufficient resources and accountability for supervisors.
More generally, our approach to regulation should favor policies that will help prevent future feedback loops between asset price bubbles and credit supply. A few broad principles are helpful in thinking about what such policies should look like. First, regulations should be designed with an eye toward fixing market failures. Second, regulations should be designed so as not to exacerbate the interaction between asset price bubbles and credit provision. For example, research has shown that the rise in asset values that accompanies a boom results in higher capital buffers at financial institutions, supporting further lending in the context of an unchanging benchmark for capital adequacy; in the bust, the value of this capital can drop precipitously, possibly even necessitating a cut in lending.15 It is important for research to continue to analyze the role of bank capital requirements in promoting financial stability, including whether capital requirements should be adjusted over the business cycle or whether other changes in our regulatory structure are necessary to ensure macroeconomic efficiency.16 Finally, in general, regulatory policies are appropriately focused on the soundness of individual institutions. However, during certain periods, risks across institutions become highly correlated, and we need to consider whether such policies might need to take account of these higher-stress environments in assessing the resilience of both individual institutions and the financial system as a whole in the face of potential external shocks.
Some policies to address the risks to financial stability from asset price bubbles could be made a standard part of the regulatory system and would be operational at all times--whether a bubble was in progress or not. However, because specific or new types of market failures might be driving a particular asset price bubble, some future bubbles will almost certainly create unanticipated difficulties, and, as a result, adjustments to our policy stance to limit the market failure contributing to a bubble could be very beneficial if identified and implemented at the appropriate time.
[..]
Japan's Asset Price Boom and the Lost Decade
An asset price bubble also confronted the Bank of Japan (BOJ) with tough decisions starting in the mid- to late 1980s. The extent of the asset price boom in Japan in the late 1980s can be gauged by the fact that the land surrounding the Imperial Palace in Tokyo was estimated to be worth more than the whole of California at that time. Without a doubt, the 1980s was a prosperous decade in Japan with high growth, low unemployment, little inflation, and an envied business model. During that decade, equity prices rose more than 600 percent and land prices boomed more than 400 percent.
Soaring equity and land prices during the 1980s, combined with relatively low interest rates, eased financing conditions for investment substantially.21 The ratio of bank loans to gross domestic product surged, and investment spending became the main driver of economic activity. Because of financial deregulation, banks' risk-taking behavior also increased as they channeled more funds to real-estate-related sectors and to small firms, accepting property as collateral.22 Trusting in a rising real estate market, some banks went as far as lending more than 100 percent of a property's appraisal value.
As at the Fed during the Roaring Twenties, the BOJ was concerned about the rapid rise in asset prices in the mid-1980s and the possibility that a bubble was in progress. In 1989, as asset prices continued to soar and inflation moved upward, the BOJ decided to start raising rates. The stock market collapsed at the beginning of 1990, but land prices continued to rise, and the BOJ kept tightening policy. Monetary policy only gradually reversed course in the summer of 1991 as growth declined and inflation and land prices started to move down. The subsequent decade has been termed "the lost decade." During that time, Japan suffered from anemic growth and repeated bouts of very low inflation and deflation.
Japan's experience re-emphasizes the importance of regulatory policies that may prevent feedback loops between asset price bubbles and credit provision. Indeed, during the boom, Japanese regulations that allowed banks to count as capital unrealized gains from equities may have contributed to banks' appetite for equities during the stock market run-up and to financial instability as the stock market collapsed. After the bursting of the bubble, policymakers did not quickly resolve the fragility of the banking sector, thereby allowing conditions to worsen as banks kept lending to inefficient, debt-ridden, so-called zombie firms.
On the other hand, Japan's experience does not support the need for preemptive monetary policy actions to deflate a bubble, as some commentators have suggested.23 The tightening of monetary policy during the bubble period does not appear to have led to better economic outcomes. Moreover, the BOJ did not reverse course sufficiently or rapidly enough in the aftermath of the crisis.24 Research suggests that it was the slow response of monetary policy to the deterioration in the economic outlook and fall in inflation following the bursting of the bubble that contributed to the onset of deflation.25
The Recent U.S. Experience
As highlighted in my introduction, the issues I have discussed today are especially salient because of the recent experience with house prices in the United States. It is too early to draw firm conclusions regarding all of the factors that have contributed to the rise and decline of house prices and the impact of these developments on our financial system and the macroeconomy. But the Federal Reserve and other government agencies have already begun to address some weaknesses that emerged during this period. For example, problems arose in recent years in the chain linking the origination of mortgages to their distribution to investors through structured investment products like mortgage-backed securities. Underwriting standards became increasingly compromised at origination. In retrospect, the breakdown in underwriting can be linked to the incentives that the originate-to-distribute model, as implemented in this case, created for the originators. Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. This problem was exacerbated by the bubble in house prices: Lenders began to ease standards as further appreciation in house prices was expected to ensure that risk was low, and investors failed to perform the research necessary to fully appreciate the risks in their investments, instead relying on further house price appreciation to prevent losses. The interaction between lenders' and investors' views and house prices illustrates the pernicious feedback loop I highlighted earlier.
These problems became apparent only in retrospect, in part, because the growth of the originate-to-distribute model for mortgages was an ongoing innovation in financial markets; as a result, neither the market nor regulators had sufficient information for evaluating the nature of the risks involved. Looking forward, efforts to improve scrutiny of the processes that originators use and the incentives they face, better information for consumers, improved performance of the credit rating agencies, and a number of other reforms that have been recommended by the President's Working Group on Financial Markets will be important in preventing a future bubble like that in the most recent experience--steps highlighted by Chairman Bernanke in remarks earlier this year.26
Sweep the role of the Fed, the President and Congress under the rug.
The President's Working Group on Financial Markets is the formal name of the so-called Plunge Protection Team.
At the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, Philadelphia, Pennsylvania
May 15, 2008
How Should We Respond to Asset Price Bubbles?
In my remarks today, I would like to return to the issue of how we should respond to possible asset price bubbles.1 I will first focus on the conceptual framework I use to evaluate these issues, based on a core set of scientific principles for monetary policy.2 My framing of the issues highlights the following three questions:
- Are some asset price bubbles more problematic than others?
- How should monetary policy respond to asset price bubbles? and
- What other types of policy responses are appropriate?
[..]
Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices.4 The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.
At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The decline in lending depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets.5 In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.6
[..]
The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this objective in terms of stabilizing both inflation and economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate that the Congress has given the Federal Reserve.7
[..]
After a bubble bursts and the outlook for economic activity deteriorates, policy should become more accommodative.8 As I pointed out in a paper that I presented at the Federal Reserve Bank of Kansas City's Jackson Hole conference in September, if monetary policy responds immediately to the decline in asset prices, the negative effects from a bursting asset price bubble to economic activity arising from the decline in wealth and increase in the cost of capital to firms and households are likely to be small.9 More generally, monetary policy should react to asset price bubbles by looking to the effects of such bubbles on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability.
To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.
[..]
Second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, raising interest rates may be very ineffective in restraining the bubble, because market participants expect such high rates of return from buying bubble-driven assets.12 Other research and historical examples (which I will discuss later) have suggested that raising interest rates may cause a bubble to burst more severely, thereby increasing the damage to the economy.13 Another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions. The bottom line is that we do not know the effects of monetary policy actions on asset price bubbles.
[..]
I would like to emphasize the importance of regulatory policy. Monetary policy--that is, the setting of overnight interest rates--is already challenged by the task of managing both price stability and maximum sustainable employment. As a result, it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices.
Of course, some aspects of such policies are simply the usual elements of a well-functioning prudential regulatory and supervisory system. These elements include adequate disclosure and capital requirements, prompt corrective action, careful monitoring of an institution's risk-management procedures, close supervision of financial institutions to enforce compliance with regulations, and sufficient resources and accountability for supervisors.
More generally, our approach to regulation should favor policies that will help prevent future feedback loops between asset price bubbles and credit supply. A few broad principles are helpful in thinking about what such policies should look like. First, regulations should be designed with an eye toward fixing market failures. Second, regulations should be designed so as not to exacerbate the interaction between asset price bubbles and credit provision. For example, research has shown that the rise in asset values that accompanies a boom results in higher capital buffers at financial institutions, supporting further lending in the context of an unchanging benchmark for capital adequacy; in the bust, the value of this capital can drop precipitously, possibly even necessitating a cut in lending.15 It is important for research to continue to analyze the role of bank capital requirements in promoting financial stability, including whether capital requirements should be adjusted over the business cycle or whether other changes in our regulatory structure are necessary to ensure macroeconomic efficiency.16 Finally, in general, regulatory policies are appropriately focused on the soundness of individual institutions. However, during certain periods, risks across institutions become highly correlated, and we need to consider whether such policies might need to take account of these higher-stress environments in assessing the resilience of both individual institutions and the financial system as a whole in the face of potential external shocks.
Some policies to address the risks to financial stability from asset price bubbles could be made a standard part of the regulatory system and would be operational at all times--whether a bubble was in progress or not. However, because specific or new types of market failures might be driving a particular asset price bubble, some future bubbles will almost certainly create unanticipated difficulties, and, as a result, adjustments to our policy stance to limit the market failure contributing to a bubble could be very beneficial if identified and implemented at the appropriate time.
[..]
Japan's Asset Price Boom and the Lost Decade
An asset price bubble also confronted the Bank of Japan (BOJ) with tough decisions starting in the mid- to late 1980s. The extent of the asset price boom in Japan in the late 1980s can be gauged by the fact that the land surrounding the Imperial Palace in Tokyo was estimated to be worth more than the whole of California at that time. Without a doubt, the 1980s was a prosperous decade in Japan with high growth, low unemployment, little inflation, and an envied business model. During that decade, equity prices rose more than 600 percent and land prices boomed more than 400 percent.
Soaring equity and land prices during the 1980s, combined with relatively low interest rates, eased financing conditions for investment substantially.21 The ratio of bank loans to gross domestic product surged, and investment spending became the main driver of economic activity. Because of financial deregulation, banks' risk-taking behavior also increased as they channeled more funds to real-estate-related sectors and to small firms, accepting property as collateral.22 Trusting in a rising real estate market, some banks went as far as lending more than 100 percent of a property's appraisal value.
As at the Fed during the Roaring Twenties, the BOJ was concerned about the rapid rise in asset prices in the mid-1980s and the possibility that a bubble was in progress. In 1989, as asset prices continued to soar and inflation moved upward, the BOJ decided to start raising rates. The stock market collapsed at the beginning of 1990, but land prices continued to rise, and the BOJ kept tightening policy. Monetary policy only gradually reversed course in the summer of 1991 as growth declined and inflation and land prices started to move down. The subsequent decade has been termed "the lost decade." During that time, Japan suffered from anemic growth and repeated bouts of very low inflation and deflation.
Japan's experience re-emphasizes the importance of regulatory policies that may prevent feedback loops between asset price bubbles and credit provision. Indeed, during the boom, Japanese regulations that allowed banks to count as capital unrealized gains from equities may have contributed to banks' appetite for equities during the stock market run-up and to financial instability as the stock market collapsed. After the bursting of the bubble, policymakers did not quickly resolve the fragility of the banking sector, thereby allowing conditions to worsen as banks kept lending to inefficient, debt-ridden, so-called zombie firms.
On the other hand, Japan's experience does not support the need for preemptive monetary policy actions to deflate a bubble, as some commentators have suggested.23 The tightening of monetary policy during the bubble period does not appear to have led to better economic outcomes. Moreover, the BOJ did not reverse course sufficiently or rapidly enough in the aftermath of the crisis.24 Research suggests that it was the slow response of monetary policy to the deterioration in the economic outlook and fall in inflation following the bursting of the bubble that contributed to the onset of deflation.25
The Recent U.S. Experience
As highlighted in my introduction, the issues I have discussed today are especially salient because of the recent experience with house prices in the United States. It is too early to draw firm conclusions regarding all of the factors that have contributed to the rise and decline of house prices and the impact of these developments on our financial system and the macroeconomy. But the Federal Reserve and other government agencies have already begun to address some weaknesses that emerged during this period. For example, problems arose in recent years in the chain linking the origination of mortgages to their distribution to investors through structured investment products like mortgage-backed securities. Underwriting standards became increasingly compromised at origination. In retrospect, the breakdown in underwriting can be linked to the incentives that the originate-to-distribute model, as implemented in this case, created for the originators. Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. This problem was exacerbated by the bubble in house prices: Lenders began to ease standards as further appreciation in house prices was expected to ensure that risk was low, and investors failed to perform the research necessary to fully appreciate the risks in their investments, instead relying on further house price appreciation to prevent losses. The interaction between lenders' and investors' views and house prices illustrates the pernicious feedback loop I highlighted earlier.
These problems became apparent only in retrospect, in part, because the growth of the originate-to-distribute model for mortgages was an ongoing innovation in financial markets; as a result, neither the market nor regulators had sufficient information for evaluating the nature of the risks involved. Looking forward, efforts to improve scrutiny of the processes that originators use and the incentives they face, better information for consumers, improved performance of the credit rating agencies, and a number of other reforms that have been recommended by the President's Working Group on Financial Markets will be important in preventing a future bubble like that in the most recent experience--steps highlighted by Chairman Bernanke in remarks earlier this year.26
Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins...
[..]
It is too early to draw firm conclusions regarding all of the factors that have contributed to the rise and decline of house prices...
[..]
It is too early to draw firm conclusions regarding all of the factors that have contributed to the rise and decline of house prices...
The President's Working Group on Financial Markets is the formal name of the so-called Plunge Protection Team.
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