Jordi Galí: Monetary Policy and Rational Asset Price Bubbles

Another paper to read:

Monetary Policy and Rational Asset Price Bubbles, by Jordi Galí, NBER Working Paper No. 18806, February 2013 [open link]: Abstract I examine the impact of alternative monetary policy rules on a rational asset price bubble, through the lens of an overlapping generations model with nominal rigidities. A systematic increase in interest rates in response to a growing bubble is shown to enhance the fluctuations in the latter, through its positive effect on bubble growth. The optimal monetary policy seeks to strike a balance between stabilization of the bubble and stabilization of aggregate demand. The paper's main findings call into question the theoretical foundations of the case for "leaning against the wind" monetary policies.

What's the key mechanism working against the traditional "lean against the wind" policy? That rational bubbles grow at the rate of interest, hence raising (real) interest rates makes the bubble grow faster. From the introduction:

...The role that monetary policy should play in containing ... bubbles has been the subject of a heated debate, well before the start of the recent crisis. The consensus view among most policy makers in the pre-crisis years was that central banks should focus on controlling inflation and stabilizing the output gap, and thus ignore asset price developments, unless the latter are seen as a threat to price or output stability. Asset price bubbles, it was argued, are difficult if not outright impossible to identify or measure; and even if they could be observed, the interest rate would be too blunt an instrument to deal with them, for any significant adjustment in the latter aimed at containing the bubble may cause serious "collateral damage" in the form of lower prices for assets not affected by the bubble, and a greater risk of an economic downturn.¹

But that consensus view has not gone unchallenged, with many authors and policy makers arguing that the achievement of low and stable inflation is not a guarantee of financial stability and calling for central banks to pay special attention to developments in asset markets.² Since episodes of rapid asset price inflation often lead to a financial and economic crisis, it is argued, central banks should act preemptively ... by raising interest rates sufficiently to dampen or bring to an end any episodes of speculative frenzy -- a policy often referred to as "leaning against the wind." ...

Independently of one's position in the previous debate, it is generally taken for granted (a) that monetary policy can have an impact on asset price bubbles and (b) that a tighter monetary policy, in the form of higher short-term nominal interest rates, may help disinflate such bubbles. In the present paper I argue that such an assumption is not supported by economic theory and may thus lead to misguided policy advice, at least in the case of bubbles of the rational type considered here. The reason for this can be summarized as follows: in contrast with the fundamental component of an asset price, which is given by a discounted stream of payoffs, the bubble component has no payoffs to discount. The only equilibrium requirement on its size is that the latter grow at the rate of interest, at least in expectation. As a result, any increase in the (real) rate engineered by the central bank will tend to increase the size of the bubble, even though the objective of such an intervention may have been exactly the opposite. Of course, any decline observed in the asset price in response to such a tightening of policy is perfectly consistent with the previous result, since the fundamental component will generally drop in that scenario, possibly more than offsetting the expected rise in the bubble component.

Below I formalize that basic idea... The paper's main results can be summarized as follows:

• Monetary policy cannot affect the conditions for existence (or nonexistence) of a bubble, but it can influence its short-run behavior, including the size of its fluctuations.
• Contrary to the conventional wisdom a stronger interest rate response to bubble fluctuations (i.e. a "leaning against the wind policy") may raise the volatility of asset prices and of their bubble component.
• The optimal policy must strike a balance between stabilization of current aggregate demand -- which calls for a positive interest rate response to the bubble -- and stabilization of the bubble itself (and hence of future aggregate demand) which would warrant a negative interest rate response to the bubble. If the average size of the bubble is sufficiently large the latter motive will be dominant, making it optimal for the central bank to lower interest rates in the face of a growing bubble.

...

But before we lower interest rates in response to signs of an inflating bubble, it would be good to heed this warning from the conclusion:

Needless to say the conclusions should not be taken at face value when it comes to designing actual policies. This is so because the model may not provide an accurate representation of the challenges facing actual policy makers. In particular, it may very well be the case that actual bubbles are not of the rational type and, hence, respond to monetary policy changes in ways not captured by the theory above. In addition, the model above abstracts from many aspects of actual economies that may be highly relevant when designing monetary policy in bubbly economies, including the presence of frictions and imperfect information in financial markets. Those caveats notwithstanding, the analysis above may be useful by pointing out a potentially important missing link in the case for "leaning against the wind" policies.