–Should Act If Future Asset Price Crash Threatens Financial Stability

By Brai Odion-Esene and Claudia Hirsch

NEW YORK (MNI) – William Dudley, president of the New York Federal
Reserve Bank argued Wednesday that asset price bubbles do exist but that
in most cases macroprudential tools are more effective in tackling sharp
rises in asset prices, rather than relying on monetary policy that is
“too broad.”

“I am going to be a bit of a heretic and argue that there is little
doubt that asset bubbles exist and that they occur fairly frequently,”
Dudley said in remarks prepared for the Economic Club of New York.

However, he added, assessing whether there is a bubble or the size
of the prospective bubble is going to be very challenging for central
banks.

Dudley said this uncertainty means policymakers can never be sure
about the existence, size or persistence of an incipient asset bubble.
“As a result, this task of dealing proactively with bubbles will be very
difficult!”

But this should not be an excuse for inaction, he continued,
“Instead, the decision whether to act depends on whether appropriate
tools can be deployed to limit the size of a bubble and whether the
benefits of acting and deploying such tools are likely to exceed the
costs.”

For example, Dudley noted that bubbles in the credit market are
more likely to generate higher costs when they burst compared with
equity market bubbles. As a result, the benefits of preventing credit
bubbles from forming and collapsing are likely to be higher because it
could threaten the financial system more directly.

Proactive action is appropriate, Dudley said, when three conditions
are satisfied.

First, if there is a meaningful risk of a future asset price crash
that could threaten financial stability. Second, that the Fed has
identified tools that might have a reasonable chance of success in
averting such an outcome. Third, the central bank is reasonably
confident that the costs of using the tools are likely to be outweighed
by the benefits from averting the prospective crash.

Dudley proposed three sets of tools policymakers can use to respond
to asset price bubbles; the bully pulpit, macroprudential tools and
monetary policy.

He noted that some make the argument that the Fed should “lean
against” asset price bubbles. “It is not clear to me that a modest
tightening in monetary policy beyond that needed to achieve full
employment and price stability in the absence of a bubble would
represent a favorable cost-benefit trade-off,” Dudley countered.

He added that, “The costs of the deviation from the optimal
monetary policy in terms of lost output and employment might be high
relative to the benefits of a somewhat smaller bubble. This seems likely
to be the case in most instances.”

And although historical experience does not suggest that bubbles
are very sensitive to the level of short-term interest rates, Dudley
acknowledged some evidence “that a tighter monetary policy will reduce
desired leverage in the financial system by flattening the yield curve
and reducing the profitability of maturity transformation activities.”

But for now, he continued, monetary policy appears to be inferior
to macroprudential tools that seek either to limit the size of
prospective bubbles or to strengthen the financial system so that it is
more resilient when asset prices fall sharply.

Macroprudential tools, such as regulatory and supervisory actions,
could be designed to temper demand or increase supply in the asset
subject to the bubble, Dudley said, “or to increase the ability of
skeptics to take the other side of the market in which the bubble may be
occurring.”

However, such tools are difficult to use effectively in practice,
he added, and it is important that regulators have the ability to apply
macroprudential tools broadly throughout the financial sector.

“A lot more work will be required to develop a portfolio of tools
that could be used, that would be effective and would not be subject to
significant evasion or unintended consequences,” Dudley said.

He said use of the bully pulpit would allow the central bank to
signal its concern regarding a rapid rise in asset prices. This would
raise the risks that the talk might foreshadow more forceful action and
so temper behavior.

So while asset bubbles might be hard to discern, Dudley concluded
that on the basis of cost vs. benefit, “I will argue that, in most
cases, use of the bully pulpit and macro-prudential tools, such as rules
limiting loan-to-value ratios or leverage, are likely to prove superior
to monetary policy.”

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