Jean-Claude Trichet: Asset price bubbles and their implications for monetary
policy and financial stability
Keynote address by Mr Jean-Claude Trichet, Governor of the Bank of France, at the Asset Price
Bubbles conference held at the Federal Reserve Bank of Chicago, Chicago, Illinois, 23 April 2002.
* * *
Ladies and Gentlemen,
It is a great honour and pleasure for me to talk today in Chicago at the invitation of the World Bank and
the Federal Reserve Bank of Chicago in front of such a distinguished audience on the theme of asset
price bubbles. As a central banker, my main focus will be on the implications of asset price
developments and bubbles for both monetary policy and financial stability.
The far-reaching changes observed over the last decade on financial markets, the growing role of
these markets for the financing of the economy, and the evidence gathered over the recent period on
the key role that financial factors may play in shaping and amplifying the business cycle, have drawn
attention to the relative importance of asset prices and wealth effects on the real economy.
There are at least two reasons why asset prices and wealth effects may have grown over the last
decade:
first, changes in asset valuations, mainly driven by the rise in the new economy stock prices

from the mid-1990s and their subsequent collapse in 2000, have been dramatic. This is well
documented for the United States. But, even in Europe, where the influence of the so-called
"new economy" is more modest, the rise in stock prices has also been significant;
second, these changes have probably influenced private spending more than past asset

prices movements did because of the more widespread share ownership observed in a
number of industrialised countries. As far as France is concerned, market capitalisation as a
percentage of GDP increased approximately fourfold between 1990 and 2000 (28% to
110.5%) and we have some evidence that the share of Households' equity holdings in
financial assets has also risen.
All of these developments have recently raised the issue of whether monetary policy should react to
financial asset prices, and more generally to asset prices. The motivation is two-fold: not only could
the large swings, misalignments or even bubbles, on asset prices endanger price stability, which is the
main objective of most central banks, but also they could impinge upon financial stability, which is an
other important goal of central banks. Let me now develop these two points.
1. Implications for monetary policy
Transmission channels of monetary policy
The role asset prices may play in the transmission mechanism of monetary policy is well known
theoretically, although quite difficult to characterise empirically. Monetary policy mainly controls the
interbank overnight rate, which is not directly relevant for any material economic decision. The way to
which monetary policy affects the real economy is when it impacts on relevant financial prices, i.e.
when it moves the whole yield curve, or when it affects the exchange rate and other assets prices.
There might be several channels through which the policy rate can affect asset prices or asset
valuations:
first, changes in interest rate modify people's expectations about future economic growth,

and thus their profit expectations;
second, monetary policy decisions may change the set of discount factors economic agents

apply to their profit expectations or to the future stream of services or revenues from the
asset they hold (housing for instance);
 finally, interest rate changes may induce portfolios' shifts amongst assets that may in turn
affect their relative prices.
BIS Review 28/2002
Besides this, and for the sake of simplicity, I will call it the "interest rate channel", changes in asset
prices also generate wealth effects that may have a significant impact on several components of
aggregate demand, namely consumption and investment. These wealth effects feed through to the
economy via various channels, such as a direct increase in net wealth, which may lead to a rise in
consumption because of households' inter-temporal smoothing behaviour; via Tobin's Q, which
activates firms' investment; or via an increase in the value of collaterals, which may reduce agents
external financing constraints and enhance final spending, in accordance with the "broad credit
channel". Although the evidence is mixed about the effectiveness of the wealth channel, even in the
United States1 , it is likely to have increased over recent years. Moreover, asset prices fluctuations or
changes might also activate some confidence or expectations channels that may in turn influence
households' or firms' spending decisions. For all of these reasons, asset prices have a particular role
in the conduct of monetary policy.
How should central banks react?
Does this mean that monetary policy should react directly to asset prices? Or, more precisely, should
asset prices be directly taken into account by the central bank's reaction function? This issue is still
debated amongst researchers and academics; my feeling is that we should remain extremely cautious
about it, perhaps because it would be like opening Pandora's Box if we started setting our key policy
rates according to asset price changes. Another reason for being extremely cautious is that assessing
asset prices' valuations is a very challenging exercise. And what matters is not only the asset price
level per se, or the pace of its change, but also its deviation from a highly hypothetical fundamental
value, which basically is hard to measure or determine.
Although, from time to time, it may seem that asset price dynamics are not really correlated to overall
economic development, it is generally hard to assess whether these dynamics are rooted in some
deep fundamental changes or whether asset prices evolve according to some "pathological path". The
recent "tech-stock bubble" provides us with an illustration of such a difficulty: while one was witnessing
the "irrational exuberance" in 1996, the surge in capital spending associated with the development of
new technologies resulted in a faster productivity growth, which in turn boosted equity prices. At that
time, uncertainties about fundamentals (was there an American miracle?) made difficult a proper
assessment of asset valuations, although the large movements in asset prices where a concern for
central banks.
However, when expectations reverse, for example due to the reassessment of expected profitability in
the economy, and consequently asset prices decrease, the point is to determine whether the attitude
of the central bank ought to be different in order to preserve monetary and financial stability. That is,
some could argue that the central bank's response should be asymmetric. In the booming phase, as
long as price stability is not endangered, central banks do not react to the rise in asset prices.
Conversely, in the recession phase or when a bubble bursts, central banks could consider reacting if
they deem that monetary and financial stability is endangered. What could then restrain them from
doing it? Such an asymmetric reaction, all the more if it seems to be systematic, has actually a cost,
pointed out in the literature, since it may generate some moral hazard problems: as long as economic
agents believe the central bank will ultimately make use of its "safety net", there is an incentive to
invest on riskier projects in order to magnify expected returns, keeping in mind that potential losses
are likely to be limited.
Would then, a systematically symmetric reaction by a central bank to asset price changes solve this
problem? I would not share that view, because central banks cannot accurately assess the deviation
of asset prices from their highly hypothetical fundamental value. To illustrate my point, let us consider
a situation in which the central bank fails to diagnose the presence of a bubble, and therefore does not
react appropriately to the surge in asset prices, then agents may become involved in riskier projects
without having consciously taken the decision to accept greater risk, but on the ground of what they
1
Cf. Martin LETTAU and Sydney LUDVIGSON (2001): "Understanding trend and cycle in asset values: bulls, bears and the
wealth effect on consumption", CEPR discussion paper, n° 3104, December.
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have interpreted as a sound financial and economic environment. As a result, we have shift to another
problem, which is close to the idea of "disaster myopia".2
The issue of measuring price stability
However, this raises another issue, especially in the current context of muted inflationary pressures
but ample fluctuations in asset prices: are we measuring inflation accurately? Is price stability being
ensured, in the context of large movements in asset prices? Shouldn't asset prices be taken into
account when defining price stability? Up to now, this debate has focused on the role asset prices may
play as leading indicators of inflation: one rationale behind this thinking may be that asset valuation is
computed in a forward looking manner, and therefore asset prices embed expectations about future
economic growth and future inflationary pressures. Empirical evidence gathered on such an issue tend
to support the idea that some asset prices, housing prices in particular, may actually play such a role.
However, this theory has to be qualified by the fact that, as I mentioned earlier, wealth effects are
difficult to establish in a definitive manner. This is probably less true for the US, although this is
debatable and could be discussed in this conference, but this is more likely to be true for the euro
area. Moreover, there might be a danger that asset prices diverge from the CPI, as this was observed
over the last few years. There might be an internal conflict here if the objective of price stability is
defined by aggregating the changes in the CPI and the changes in asset prices, and this is a crucial
issue since the nature of both types of prices is fairly different.
So, do asset prices have a key role to play in the conduct of monetary policy? To answer this question,
I will briefly describe the way we deal with asset prices in the conduct of the European single monetary
policy. As you already know, the ECB's monetary policy strategy is based on a two-pillar approach.
This concept of monetary policy was designed to promote the conduct of a sound monetary policy
whilst coping with the complexity of the set of major determinants of inflation - fully recognized by the
Governing Council of the ECB. That is the reason why we rely upon a binocular vision of the factors of
inflation, i.e. as a monetary phenomenon according to pillar 1 and as the result of short-term to
medium-term developments of inflation according to pillar 2. This framework is also well suited to
addressing the asset price bubble issue.
In this context, the first pillar is very helpful for analysing how ample liquidity is within the euro area,
that is to say how much the broad monetary aggregate (M3) deviates from its reference value, and
how economic agents make use of this liquidity: credit and loan developments are carefully monitored,
in line with economical and financial developments. Portfolio shifts are also an important part of the
monetary analysis. Too rapid a credit expansion to the private sectors associated with large portfolios
shifts towards equities and a strong rise in stock or asset prices would, under normal economic
conditions, signal the risk of a bubble formation.
The second pillar consists of a wide range of economic and financial indicators: stock and bond prices,
housing prices, exchange rates are also analysed in depth. Obviously, their assessment is made in the
context of maintaining price stability over the medium term, and the ECB does not react to their signals
unless price stability is endangered. To recap, if monetary policy does not react directly to asset price
developments or to an asset price bubble, it has clearly to take under consideration all the
consequences of these developments on aggregate demand and aggregate supply, on economic
agents' confidence and expectations, since they may at some point affect price developments.
Let me now turn to my second point, that is the implications of asset prices bubbles for financial
stability.
2. Implications for financial stability
Over the last decade, we have experienced several financial crises and contagion episodes: just to
name a few episodes, the Mexican crisis in 1994-1995, the Russian-LTCM in 1998, the "Tech-Bubble"
that ended in 2000, or more recently the financial crises in Argentina and Turkey. However, recent
2
J. M GUTTENTAG and R. J HERRING (1986), "Disaster myopia in International Banking", Essays in International Finance,
164, Princeton University.
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research3 has shown that, if the frequency of financial crisis is not significantly different from what was
observed in previous periods over the long run (1883-1998), recent episodes were certainly shorter,
but perhaps more severe.
Although financial globalisation has brought about improved macro-economic efficiency, via a more
efficient allocation of resources and capital, liberalised capital flows, increased competition on financial
markets, increased transparency (apart from the recent ENRON episode!), changes in asset prices
have also become more pronounced and have experienced clear misalignments or deviations from
their "equilibrium" levels. Moreover, credit seems to have played a greater role in asset prices
fluctuations. Initially observed during the "speculative bubbles" of the 1980s and early 1990s, this
trend has persisted, if not amplified.
Several factors may explain these recent and abnormal patterns in asset prices. I shall give a few
examples.
First, "short-termism": some market participants may have become more inclined to be

mostly preoccupied with their short-term results. This trend might result, in particular, from
growing pressure to yield good results immediately. However, these results are not
necessarily sustainable. Marking-to-market financial products may also have contributed to
this widespread focus on immediate financial performances. This emphasis on short-term
performance may result in increased volatility in the price formation process: the shorter the
investment horizon of markets participants, the bigger the impact of any new information on
prices.
 Second, herding or mimetic behaviour: mimetic behaviour is of course by no means a new
phenomenon on financial markets. Technological developments on markets may however
have gradually reinforced this type of behaviour, as participants are under increasing
pressure to follow their peers through matching the performance of a benchmark. There is
no doubt that the spread of benchmarking allows fund managers and clients to better assess
their performance against that of other funds. But, in a context of growing competition within
the sector, it may well have increased mimetic behaviour. Some market participants
operators (whose own compensation is closely linked to the relative, rather than absolute,
profit and losses they generate) may indeed have come to the conclusion that it would be
better to be wrong along with everybody else, rather than running the risk of being right
alone. A striking example of rational mimetic behaviour is the influence that hedge funds
enjoyed as "opinion leaders" and trend makers. By its nature, trend-following amplifies the
imbalance that may at some point affect a market, potentially leading to vicious circles of
price adjustments and liquidation of positions. Moreover, more and more participants are
able to access directly to financial markets, while the expertise to deal with a larger set of
technical information is not evenly distributed. This may also reinforce the role of "gurus".
Third, index management: as a fund management technique, it has proven very popular on

equity markets and may have contributed to exacerbating movements in financial asset
prices. Because their goal is to mimic the performance of indices, "passive managers" try
constantly to match the composition of their benchmark. They thus help to amplify market
trends, buying more as the market rises and liquidating more as the market drops. It can be
argued that index funds distort the price of the targeted indices and that, as a result, the
indices end up creating rather than measuring performance.
Last but not least, the impact of risk management techniques on market dynamics is

particularly enlightening with regard to the question of asset price overshooting. Value-at-risk
calculations have become a crucial element of the standard approach used by market
participants to evaluate the risk inherent in their market activities and to set up exposure
limits. Of course, central banks and financial institutions should continue to encourage the
use of these instruments. But, in times of financial turmoil, the growing use of sophisticated
risk management techniques by financial intermediaries might have had the paradoxical
effect of amplifying the initial shock, exhausting liquidity and contributing to contagion
3
M. BORDO, B. EICHENGREEN, D. KLINGEBIEL and M. S. MARTINEZ-PERIA: "Is the Crisis Problem Growing More
Severe?", CEPR, September 2000.
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phenomena. Regardless of the intrinsic qualities of these risk management tools, we see
that their growing use in the same fashion by all market participants may have produced
pernicious effects. When market players rely on converging risk evaluations, they tend to
take the same decisions at the same time, thus amplifying the initial shock to prices and
trading volumes.
All those factors have one consequence in common: they encourage homogenous behaviour and
reactions to the detriment of the diversity that is indispensable to the smooth functioning of financial
markets.
So, what are the possible policy implications of these recent patterns or trends on financial markets?
My opinion is that financial authorities might reflect on some ways to foster behavioral diversity in
financial markets. As we have just seen before, some specific factors, such as short-termism, mimetic
behaviour etc... have tended to make "contrarians" less pro-active on financial markets. As a
consequence, in order to safeguard the smooth functioning of the markets, the diversity of participants'
behaviours must be protected or even reinforced. This necessary diversity should logically reflect
natural differences in time horizons, strategies and reaction functions of market players. On this point,
I would like to explore amongst many others three possible avenues for future action for both
monetary or financial authorities and the financial industry.
First avenue: Strengthening the continuing efforts aiming at market transparency
Experience shows that uncertainty and incomplete information are determining factors in mimetic
behaviour. These shortfalls in market transparency make mimetic behaviour seem rational to agents,
who prefer to follow bigger participants, who are thought to be better informed, rather than develop
their own analysis. Therefore, strengthening transparency continues to be the priority. In the same
vein, attention should be paid to expand the skills and competencies required by the analysis of a
more detailed and complex information. Transparency is useless if only a limited number of experts
are able to deal with it.
One of the objectives of transparency is to enable better differentiation of borrower creditworthiness. A
key feature of mimetic behaviour is that all borrowers are "tarred with the same brush". So when one
emerging economy encounters difficulties, all neighbouring countries are treated in the same way -
regardless of their actual economic and financial situation. The same applies to businesses operating
in the same economic sector. Transparency may have improved since the Asian crisis, which may
explain why contagion effects are nowadays rather subdued (sees Argentina...). Let us continue and
reinforce these efforts.
Second possible avenue: Taking into accounts the medium and long-term perspective of some
market participants
Some investors, such as pension funds and insurance companies, have to invest funds in order to
enable their customers to build up wealth over the medium and long-term, notably in preparation for
retirement. Consequently, these types of investors are supposed to behave differently from traders
and short-term investors, who are working on a very different time horizon. But at times it seems that
they are all pushed to behave in much the same way, on the basis of a very short-term horizon.
To preserve, and even restore, their specific investment approach, these investors might be more
shielded from excessive short-term pressures. This objective raises considerable difficulties, because
it touches on the way in which the performances of medium and long-term funds and life insurance
companies are assessed. In other words, this objective concerns the accounting standards and
practices they use. It might imply that some rules and standards would be adapted to the medium and
long-term horizon used by these entities.
Third possible avenue: Diversify the risk management tools of financial institutions
As I mentioned earlier, even the best techniques can have adverse effects when used on a standard
basis and by all participants. To some degree, this is perhaps what has happened to value-at-risk
based techniques, which have been, for very good reasons, massively adopted by the financial
industry. Because they use more or less similar parameters and suffer from the same weaknesses -
for example, they did not take market liquidity into account adequately at the time of the 1998 crisis -,
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such tools might tend to give converging signals to those that use them. They thus encourage the
mimetic behaviour that I discussed previously.
Of course, the fact that some market participants are more sophisticated than the average is a
guarantee that standardisation will remain limited, since they will develop techniques that are little
used by others.
However, supervisors might help, and obviously are already helping to spread the idea that financial
institutions should round out their current range of risk management tools to include extensive use of
stress testing. This technique offers a better reflection of the varying situations of institutions and of the
diverse perceptions that institutions have of exceptional events. The application of stress testing
techniques and their results are thus inherently more diversified than those resulting from methods
based on the value-at-risk approach.
3. Conclusion
Asset price developments are a serious cause of concern for central banks since they may impinge
upon both price and financial stability. And I would like to stress what I feel is the highly
complementary nature of price stability and financial stability objectives: price stability is the bedrock
on which financial stability is built.
However, in my opinion, it is clearly not opportune to introduce asset prices into a monetary policy rule
the central bank should commit to or in the central bank's reaction function. Besides the reasons I
already mentioned, another issue is: which asset price should we take into account? Should we limit to
stock prices, or extend the rule to housing prices, exchange rate, the cost of capital and so on? I would
also not support the idea of introducing asset prices into the measurement of inflation or the definition
of price stability. My first reason is that the nature of goods and services on the one hand, and assets
on the other hand, is quite different, and so is the information contained in their prices. Another reason
is that asset prices are highly volatile, much more volatile than other prices, especially in the current
context of low inflation. Consequently, it might be difficult to implement a sound monetary policy by
focusing on highly volatile indicators. Finally, it is highly questionable that one could determine
scientifically what an asset price equilibrium value is. Some participants will probably address some of
these issues during the conference, which are of great interest for central bankers.
I also provided you with some examples of possible options monetary and financial authorities may
take to help improve the functioning of the financial cycles. There is a lot of merit in embarking upon
an overall review of regulatory, accounting and tax rules and regulations, as well as of codes of good
conduct and good practices, and finally of structural developments of markets themselves. I am
convinced that this review, triggered not only by macro-financial considerations but also by dramatic
micro observations, like ENRON, is likely to help identifying possible amendments and improvements
that could, protect and enhance not only the integrity but also the behavioural and conceptual diversity
which should make an essential characteristic of modern financial markets.
I thank you for your attention.
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