Jean-Claude Trichet: Asset price bubbles and monetary policy
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Mas lecture,
Monetary Authority of Singapore, Singapore, 8 June 2005.
The references for the speech can be found on the European Central Bank's website.
* * *
Introduction
Mr Minister, Mr Chairman,
Ladies and Gentlemen,
I would first like to thank Chairman Lee Hsien Loong for giving me the opportunity to address such a
distinguished audience. Let me tell you that I consider today's topic "asset price bubbles and monetary
policy" to be one of the most challenging issues facing a modern central bank at the beginning of the
21st century. The economics profession has taught us a lot about the merits of consumer price
stability, about the value of independent central banks and the importance of credibility and
commitment to the objective of price stability. And a broad consensus has emerged on these issues,
which is actually reflected in a number of very well-designed central bank statutes all over the world,
with the ECB being only one, though prominent, example.
Consumer price inflation has been successfully contained for quite some time now at least in the major
OECD economies. But at the same time we observe large cycles in a variety of asset prices
accompanied by ample global liquidity. Economists at the Bank for International Settlements have
recently been arguing that the coincidence of low consumer price inflation and high asset price
inflation is not by chance. They have labeled this the "paradox of central bank credibility" and hinted at
the possibility that due to central banks' success and gained reputation in fighting inflation, inflationary
pressures would first show up in asset price inflation and increase the vulnerability of financial
systems.1 Is this something a central bank should be concerned about to a degree that policy
strategies have to be amended? Should a central bank react to asset prices directly or indirectly with
regard to possible future threats to price stability? Do we know which of the observed asset price
booms are bubbles? Do we need to know? These are important questions and to most of them a fully
satisfying answer is still lacking. In the following I will try to deal with some of these issues. I will start
by exploring what we know about the existence of asset price bubbles. Then I will discuss whether
asset price bubbles are necessarily harmful developments. Both sections are meant to caution against
quick calls for policy intervention whenever unusual and seemingly excessive asset price
developments are observed. I will then list some empirical stylized facts about past asset price boom
and bust cycles to provide the background for reviewing the recommendations obtained from the
economics literature on what is the best monetary policy reaction to asset price booms. I will then
explain how the Eurosystem deals with the challenging issue of possible asset price bubbles within the
framework of the ECB's monetary policy strategy.
Are we sure asset price bubbles exist?
There is no consensus about the existence of asset price bubbles in the economics profession. Well
reputed economists claim that even the most famous historical bubbles - e.g. the Dutch Tulipmania
from 1634 to 1637, the French Mississippi bubble in 1719/20, the South Sea Bubble in the UK in 1720
as well as the worldwide New Economy Boom in the 1990s2 - can be explained by fundamentally
justified expectations about future returns of the respective underlying assets (or tulip bulbs). Thus
according to some authors, the observed price developments during the just mentioned episodes -
although exhibiting extremely large cycles - should not be classified as being excessive or irrational.
For example with regard to the New Economy boom of the late 1990s it has been argued that
uncertainty about future earnings prospects increases the share value of a company, especially in
times of low risk premia.3 The claim can be derived in a most standard stock valuation model, where
the price-dividend ratio is a convex function of the mean dividend growth rate. The mean dividend
growth rate in turn depends obviously on future expected earnings of the company. Heightened
uncertainty about future earnings, will increase the price dividend ratio. It has further been claimed that
assuming apparently reasonable parameter values with regard to the discount rate, expected earnings
growth and most importantly the variance of expected earnings growth, one can reproduce the
NASDAQ valuation of the late 90s and its volatility. There would thus be no reason to refer to a
dotcom bubble. I do not mention this example because I believe the NASDAQ valuation of the late 90s
has not been excessive. However, if one takes the narrow definition of bubble very often used by
these economic researchers4, there exists a fundamental difficulty in calling an observed asset price
boom a bubble: It must be proved that given the information available at the time of the boom,
investors processed this information irrationally. This is as the above example shows a formidable
task.
Some economists would even argue that apparent evidence of irrationality should always be
interpreted as a sign of hidden costs (to acquire or process information in a rational way) or model
misspecification (which is responsible for the divergence between the model based fundamental price
and the observed price). According to this view, rationality of behavior is not a falsifiable hypothesis
but an organizing principle of economic thinking. The conclusion of this line of thinking - which by the
way I certainly do not share - would be that bubbles cannot exist by definition5.
I rather tend to believe that occasionally we observe behavioral patterns in financial markets, which
can even be perfectly compatible with rationality from an individual investor's perspective, but
nevertheless lead to possibly large and increasing deviations of asset prices from their fundamental
values, until the fragile edifice implodes. A simple example of a bubble occurring possibly despite
individual rationality, is herding behaviour triggered by some investors' rather short reporting horizons.
In the same vein, some policy makers and economists had stressed in the past that market
microstructure developments6 and regulatory changes, i.e. Basel II and IAS397, had to be carefully
designed in order not to lead in the future to more rather than less pro-cyclicality and volatility in asset
prices.
I would argue that yes bubbles do exist, but that it is very hard to identify bubbles with certainty and
almost impossible to reach consensus about whether a particular asset price boom period should be
considered a bubble or not.
Economists have often been described as "the great prophets of the past". Despite the magnificent
words, this appellative is obviously not intended to be a compliment but rather a criticism for not being
able to predict the future. In light of the difficulties to interpret even extreme historic developments,
perhaps we should think more positive about great prophets of the past. After acknowledging the
problems to identify a bubble even after the cycle has collapsed, it is not surprising that the challenge
to call a boom a bubble is of another order of magnitude if the judgment has to be made in real time,
which means when the boom is developing. Prominent economists have even considered this to be an
impossible task.8 I would like to emphasize that acknowledging the possibility of detecting a bubble,
does not imply that central bankers have more information or better tools for analysis, which would be
a position difficult to defend.
However, the question whether a boom is a bubble, is for many practical purposes more of semantic
than of real importance. For policy makers, the important question is whether we can identify a
combination of events in the financial and/or real sectors, which expose the financial system to a
significantly increased level of risk. A financial crisis can make it very difficult to maintain price stability.
This is demonstrated by the fact that all major deflations in the world were related to substantial falls in
asset prices. The growing academic literature on early warning signals already provides some
progress. Researchers from the Bank for International Settlements and the European Central Bank in
two separate studies illustrate this point.
It has been shown that an indicator defined to provide a warning signal when both the credit to income
ratio and real aggregate asset prices simultaneously deviate by 4 percentage points and 40%
respectively, from their trends, would have predicted 55% of financial crises three years in advance.9
The likelihood that this indicator triggered a false alarm has been at least historically very small
(around 3%). Considering deviations of the credit to income ratio beyond a threshold of 4 percentage
points alone as warning signal, would have predicted even 79% of financial crises, although in this
case the indicator would have provided a false warning signal in 18% of times.10
In another paper, ECB staff found that defining asset price booms as simple deviations from trend
beyond a given threshold11 and classifying the resulting boom periods in high-cost and low-cost
depending on the depth of the post-boom recession, broad money and credit developments are
among the few early indicators of high cost asset price boom periods.12
I consider it the duty of central banks to communicate the results of their analysis with regard to
financial stability and potential risks for the financial system and the economy as a whole to the public.
This conviction is shared by many of my colleagues as can be seen by the increasing number of
financial stability reports published by major central banks, including the ECB. Another example is the
Financial Stability Forum, which convened in 1999 and brings together on a regular basis national
authorities responsible for financial stability in significant international financial centres, international
financial institutions, sector-specific international groupings of regulators and supervisors, and
committees of central bank experts. The Financial Stability Forum publishes a status report twice a
year on recent and ongoing work relevant to strengthening financial systems.
The welcome increase in transparency with regard to financial stability analyses, does however not
preclude the question whether and to which degree central banks should react to threats of financial
stability - potentially triggered by asset price booms - at times other policy makers like supervisory or
fiscal and tax authorities are unable or unwilling to take appropriate action.
Are asset price bubbles dangerous?
The question in the title of this section is not a rhetoric one. The answer is not so straightforward as
one might tend to believe. Certainly not all asset price booms are dangerous. Booms are likely to be
costly if associated with high leverage, which is, for example, usually the case in housing price booms.
Economists have argued since long that it is conceivable that a boom-bust cycle ridden development
could potentially exhibit a stronger rising trend growth path than one would observe for a notoriously
boom-free country.
For example, some researchers have defended the idea that it is possible that asset price bubbles
moderate the effects of financial market frictions, like credit constraints and improve the allocation of
investment, despite the occasional busts.13 Of course, one cannot exclude that it could be beneficial
for long run growth to ease borrowing constraints, but it should not be at the expenses of a stable
financial system, which favours an efficient allocation of capital and it is thus intrinsically related to the
good performance of the economy and its resilience to shocks.
A different but related argument claimed by the literature is that the optimal degree of vulnerability to
banking crises must not be zero. Under certain conditions it can be optimal not to be fully insured
against liquidity crises in the banking system, in order to spur financial intermediation, increase the
amount of credit available for investment and thus foster growth in the long run.14
Each of these theoretical findings is clearly derived under special assumptions, but nevertheless they
provide food for thought. I mention these examples in order to remind us of being prudent in calling for
policy makers' corrective actions when some risk of financial fragility is detected. Even if the existence
of a bubble would be generally acknowledged - an unlikely situation in light of what I mentioned in the
previous section - the policy maker's response - if any - has to be carefully devised, especially with
regard to its long run effect on the working of the financial system.
Some stylized facts about asset price boom periods and monetary policy
Let me now turn to present some empirical stylized facts about asset price bubbles. My goal is then to
focus on the link to monetary policy. A number of researchers have devoted some efforts to analyzing
historical boom-busts cycles in asset prices in order to detect regularities with regard to the costliness
of booms, and to assess the potential for identifying dangerous booms at an early stage. Different
studies emphasize different aspects, and use different methodologies. However, they coincide on
pointing out a range of characteristics, and I would like to call your attention to some of them.
A recently conducted IMF study acknowledges the importance of housing price booms and compares
equity and housing bust periods. It reaches the conclusion that although housing price busts are
overall less frequent, they are more likely conditional on the existence of a boom. Historically, housing
price booms have been followed by busts about 40 percent of the time, while equity price booms are
followed by busts only 25% of the cases. Housing price peak to trough periods are longer on average,
and, despite the fact that the decline in prices is somewhat smaller, the associated output losses are
notably bigger. The output losses incurred during a typical housing price bust amounts to 8 percent of
GDP, which is double the average loss during an equity price bust. The reason is a different exposure
of the banking system to mortgages than to shares. In this respect, bank-based financial systems incur
larger losses than more market-based financial systems during housing price busts, while the opposite
is true for equity price busts. This finding is corroborated by the fact that all major banking crises in
industrial countries during the post-war period coincided with housing price busts.
Other studies recently confirmed that developments in the monetary aggregates and credit play an
important role for the development of asset price boom episodes. Although the issue of empirical
causality between asset prices on the one side and money and credit developments on the other side
is a complicated one, the potential role of credit and money as driving asset prices is straightforward.
A bubble is more likely to develop when investors can leverage their positions by investing borrowed
funds. One would expect to see similar developments in credit and money as credit is the main
counterpart to money. Furthermore, a high money stock might signal large amounts of liquidity waiting
to be invested in potentially higher yielding opportunities, which could then fuel a bubble once a trend
has been triggered and herding behaviour sets in. Further on, a high level of outstanding debt will
increase the negative effects of asset price declines, through the forced liquidation of leveraged
positions and possible defaults, which in turn put additional pressure on asset prices. In this respect it
should not be surprising that both money and credit variables have recently been found to be pertinent
indicators to predict financial crises and identify costly asset price boom episodes.15 For example there
is evidence that during - and already in the two years before - asset price booms, real (broad) money
growth has been about two percentage points higher in those booms that led to serious recessions
than in those that did not.16 More recent evidence along the same lines, seems to suggest that it is
equally useful to monitor real residential property price growth and real investment growth rates in
order to detect potentially costly asset price boom periods at an early stage.17]
Actual consumer price inflation is not a good early indicator to distinguish costly asset price booms
from more benign booms. Only in the last boom year is inflation significantly higher in high-cost than in
low-cost booms.18
How should monetary policy react to asset price booms?
In the following section I will briefly review the economics underlying the various practical
recommendations for central bankers on how optimally to react to or take account of asset price
booms.
The orthodox view: no special role for asset prices
In its strong version the orthodox view claims that price stability is a sufficient condition for financial
stability. It is argued that the stable and predictable environment provided by a central bank
successfully maintaining price stability over the short-term prevents financial crises.19 This view has
been in the meantime empirically rejected. Financial crises can occur also in times of relative
consumer price stability. However, they often undermine conditions for maintaining price stability.
Therefore, a concept of price stability with a longer horizon is clearly associated to financial stability.
The Japanese stock market and property price boom in the late 1980s is another vivid example of this.
The more moderate version of the orthodox view though has many supporters, especially among
central bankers. It says that asset prices should be ignored beyond their impact on consumer price
inflation via the regular transmission mechanism channel. The regular transmission mechanism would
include wealth effects resulting from changes in asset prices. Reference to the regular transmission
mechanism is the key distinction to some other reaction patterns, like "leaning against the wind", which
will be discussed below. The strength of the regular transmission mechanism could very well depend
on asset price levels themselves. For example the size of the wealth effect following changes in the
policy interest rate could be larger the higher asset price valuations as the share of financial assets in
total wealth is then more important. But the key point is that the possibility of financial distress in case
of major price corrections is not explicitly taken into account, ex-ante. Emergency liquidity assistance
provided by the central bank in case of a severe bust with expected systemic effects is part of this
orthodox view.[20 Although being a robust theory for most of times, the orthodox view has recently
been repeatedly questioned for not being optimal in all circumstances.
Targeting asset prices
One extreme view to attribute a more prominent role to asset prices in the conduct of monetary policy
is to include asset prices in the consumer price index used to define the policy objective.21 The general
idea is to secure stable prices of current but also future consumer goods by targeting a "cost-of-life"
index. Assets are a claim to future consumption and it has been argued that the asset price today
should be a reasonable proxy for future prices of consumer goods. Today there is something close to
a consensus among economists and central bankers that targeting financial asset prices is a bad idea.
The ECB has recently provided an overview over the main arguments in a recent Monthly Bulletin
article22, so I will constrain myself in listing the arguments against asset price targeting. First, in reality
asset prices are a bad proxy for future CPI inflation, as asset price changes are driven by changes in
fundamentals and not only inflation expectations. Second, targeting asset prices would increase risk
taking by private agents in anticipation of the asset price stabilizing attempts of monetary policy. This
is the well known moral hazard argument. Third, with rational forward-looking private agents, there
exists the possibility of a circular relationship between monetary policy and asset prices. Asset prices
would partly determine monetary policy, while simultaneously expected future monetary policy
determines today's asset prices. As a consequence, inflation could be purely determined by
selffulfilling market expectations and thus become extremely volatile. This problem is known under the
heading "inflation indeterminacy". Fourth, if the central bank targets CPI inflation by means of a
successful monetary policy strategy taking into account all indicators of inflationary pressure (including
signals from asset prices), targeting asset prices directly would amount to double counting inflationary
pressure derived from asset prices. Fifth, the weight for asset prices in a combined price index is
ambiguous. The weight for asset prices could be extremely large if based on traditional expenditure
shares. Using the relative usefulness to forecast CPI inflation the weight would be much smaller. The
methodological discussion has not yet converged. And finally, central banks' lack sufficient control of
asset prices. In the long run asset prices are driven by fundamental factors and not monetary policy.
Pricking asset price bubbles
The focus of serious academic debate has moved away from this approach more recently, but the
view that central banks should act decidedly against suspected asset price bubbles occasionally
surfaces among market observers. The roots of this position can be traced back to the so-called
"liquidationist" view, which was widely entertained by mainstream economists in the context of the
heated debate over the stock market boom of the 1920s in the US. The view had some prominent
advocates within the Board of Governors of the Federal Reserve System who substantiated their
inclination for a strong policy reaction to market dynamics on the grounds that the central bank, by
acting decidedly, would force liquidation of the most stretched positions without dealing further
damage on sound investment strategies and the economy more broadly. While often advanced by
economists who are otherwise most distrustful of the central bank's ability to manage economic
events, this position is now widely rejected by today's profession.23 The monetary policy instrument is
just a too blunt tool to allow the type of surgical intervention that the "pricking" of the bubble would
require.
Leaning against the wind
The leaning against the wind principle describes a tendency to cautiously raise interest rates even
beyond the level necessary to maintain price stability over the short to medium run, when a potentially
detrimental asset price boom is identified. The basic assumption behind the leaning against the wind
principle is a non-linearity best described as an asymmetric effect of positive and negative asset price
shocks. A negative shock is likely to have a larger effect than a positive one. The reasons are that
credit constraints can depend on the value of collateral and that in case of a financial crisis the whole
financial intermediation process can in the worst case completely fail. The central bank conducts a
slightly tighter policy in order to better ensure price stability over extended horizons by possibly
containing the future growth of the bubble - or at least not to accommodate it - than it would otherwise
if confronted with a similar macroeconomic outlook under more normal market conditions. By doing so
the central bank would tolerate to be significantly below its definition of price stability. This behaviour
has been compared to buying an insurance against a potentially harmful asset boom-bust cycle,
where the insurance premium to be paid is some additional tightening leading to a lower level of
inflation than would be required by the monetary policy strategy.24
Proponents of the leaning against the wind policy have typically been very careful to mention the
strong informational requirements concerning the properties of the bubble. Leaning against the wind is
advisable only when first, the probability that the bubble anyhow bursts in the near future is small,
second, the future growth of asset prices is sufficiently interest sensitive and third, the efficiency losses
rise strongly with the size of the bubble. In particular the need to carry out "small", "sufficiently
sensitive" and "strong" constitutes a severe challenge for the practical implementation of a leaning
against the wind policy.25
It should be mentioned that "leaning against the wind" has the advantage that it can to some degree
ameliorate the moral hazard problem of the purely reactive approach to asset price boom-bust cycles.
By reacting more symmetrically - being tighter in booms as well as looser in busts - the central bank
would discourage excessive risk taking, and thereby reduce overinvestment already during the boom.
This in turns leads to a smaller level of indebtedness and less severe consequences of a possible
future burst.
Thus despite this property, the leaning against the wind principle faces some other intricate issues.
First of all, bubbles, and asset price misalignments in general, may have their roots in underlying
structural imbalances. Policies designed to effectively deal with these structural causes, such as
prudential regulation or changes to the tax code, could be optimal and preferred in many cases. One
should also take into account the effects of and to what extent a leaning against the wind policy can
affect the markets. For example, it could be argued that for a small open economy leaning against the
wind with regard to equity price bubbles is infeasible. With globalised equity markets, it is unlikely that
the central bank of a small open economy would have the clout to affect domestic share prices against
a global trend. On the other hand, a disorderly market reaction to a policy intervention can never be
completely ruled out, even in cases where the policy is implemented gradually over an extended time
horizon
In my opinion, while compelling in many theoretical aspects, in practice - barring the progress of recent
research findings on the prediction of financial crises mentioned earlier - it is likely that circumstances
will be rare that a policy maker will embark with confidence on an explicit leaning against the wind
policy.
Asset prices and the ECB Monetary Policy Strategy
In the previous section I have discussed an array of possible strategies a central bank could follow in
the presence of suspected asset price bubbles. They range from the complete non-intervention to an
almost systematic reaction to asset price developments. Reasonable alternatives for policy makers are
only the two relatively more moderate suggestions. Eventually it all boils down to the question of
whether the reaction to asset prices should be limited to their impact on consumer price inflation via
the regular transmission mechanism channel or whether - accounting for effects of a boom-bust asset
price cycle may have on the soundness of the financial system and thus price stability in the medium
to long run - a central bank should occasionally consider to follow the leaning against the wind
principle. Informational requirements, the specifics of the asset price misalignment and the underlying
structural relationships of the economy will determine the feasibility and optimality of each of these two
options.
The ECB's primary objective is unambiguously the maintenance of price stability. The Governing
Council aims at an HICP inflation rate of below and close to two percent with a medium term
orientation.
I mentioned though that boom-bust cycles in asset prices do exist and can potentially harm the entire
economy, especially via the effect on the financial system. Maintaining price stability in times of
financial crises is a very difficult task. It is thus reasonable that the monetary authority monitors
carefully unusual asset price developments at an early stage. As discussed a moment ago, allowing
some short-term deviation from price stability in order to better ensure price stability over more
extended horizons might be - under very restrictive assumptions - the optimal policy to follow.26 The
principle behind it should not be misunderstood as a systematic reaction to asset price booms, but
rather as a selective response based on the careful analysis of all the available information. With
respect to the ECB monetary policy strategy, the important point to note is the following: The ECB's
monetary policy strategy does allow for taking into account boom developments without any
amendments to the strategy and without providing any additional role to asset prices. Let me be more
precise on this point.27
The ECB's two-pillar strategy rests on a broad analytical framework, which is well suited to detect risks
to price stability and to the economy as a whole. It will also help to identify the underlying distortions in
asset prices. The ECB singles out money in its monetary analysis in recognition of the fact that
monetary growth and inflation are correlated in the long term. However, the monetary analysis also
contributes to assessing the extent to which excess creation of liquidity and over-extension of credit
can be a driving force behind excessively valued assets. Detecting and understanding this link helps
the ECB form an opinion on whether an observed movement in monetary aggregates and their
counterparts might already reflect the inflating of an asset price bubble. It is then clear that a case by
case analysis based on sound information on the monetary variables (mainly broad money and credit),
on the counterparts of monetary aggregates (including the net external asset position of monetary and
financial institutions) and on the related functioning of the asset market is indispensable.
In this respect the ECB's strategic framework has in my view important advantages compared to an
inflation targeting strategy. The ECB strategy permanently and comprehensively captures longer run
risks to price stability within its monetary analysis. In the inflation targeting framework - to the contrary
- reacting to potential asset price booms will always have the flavour of introducing an exceptional
escape clause in the strategy. Proponents of inflation targeting have recommended to simply extend
the horizon of the inflation forecast beyond the standard one to two year policy horizon. I doubt that
serious inflation forecasts can be derived at this horizon given the uncertainty surrounding asset price
boom periods.28 Thus I fully share the view that the longer horizon in inflation targeting is basically a
substitute for a more structured assessment of risks to price stability.29 This risk assessment is part of
the ECB's monetary analysis.
In order to maintain the effectiveness and credibility of monetary policy, it is important to foster the
public understanding of the implications of the ECB's monetary policy strategy. The fact that our
monetary analysis uses a comprehensive assessment of the liquidity situation that may, under certain
circumstances provide early information on developing financial instability is an important element in
this endeavour.
Conclusions
Let me conclude. Experience with past asset price boom episodes tells us that we should be very
careful in calling a boom, which is observable, a bubble. Such labelling will always contain a
substantial degree of arbitrary judgment. Nevertheless, empirical evidence also reveals that it is
possible to find characteristics of potentially dangerous asset price boom developments, which are
useful from a policy maker's point of view to identify risks to long run price stability. The methodologies
to identify those threatening booms certainly need to be refined. In particular, we have to know more to
which extent we can rely on empirical analyses which, out of necessity or lack of sufficient recent
boom-bust cycles, have to pool information from various boom episodes, happening in different
countries under very specific and furthermore time-varying financial systems.
Not all boom or bubble episodes are threatening financial stability. Policy makers should not fall into
the fallacy of attempting to eliminate all risk from the financial system. Either they would be
unsuccessful (moral hazard) or they are likely to hamper the appropriate