NEW YORK – Asset bubbles are unique and difficult to identify, and while studying how central banks should respond, perhaps the best ways to attack them may be “bully pulpit and macro-prudential tools, such as rules limiting loan-to-value ratios or leverage,” Federal Reserve Bank of New York President and Chief Executive Officer William C. Dudley said today.
Poor regulation of the financial system aids in the formation of such bubbles, which “typically occur after an innovation has occurred that creates uncertainty about fundamental valuations,” Dudley told the Economic Club of New York, according to prepared text of the speech, which was released by the Fed.
Since bubbles may be “difficult to discern” and have “unique characteristics,” Dudley said, “a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.”
But uncertainty should not be an excuse for inaction. “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,” he added.
Several shared features can be used to determine “how policy might be used to temper incipient bubbles in the future.” Dudley said bubbles occur when an innovation “changes the fundamental valuation in a meaningful, but uncertain way,” followed by “significant uncertainty about how valuable the innovation will turn out to be. This leads to a divergence in expectations concerning how much the fair value of the assets should rise. I believe that this uncertainty about what constitutes fair value is important in fueling the bubble.”
In the housing market, Dudley said, the innovations were subprime lending that “made mortgage credit available to households that were much less creditworthy,” and structured finance instruments such as collateralized debt obligations (CDOs).
Another feature seen in many bubbles “is a surge in economic activity in the particular sector associated with the innovation,” and a third characteristic is “a positive feedback mechanism that tends to reinforce the belief system that underpins the extreme valuations associated with the boom.”
Also, market participants’ belief the bubble is justified, and the difficulty in shorting the asset aid in creation of asset bubbles.
In response, Dudley said, policymakers should investigate what is causing the sharp price rise for the asset in question, then evaluate the tools that might be used to curb identified imbalances, and then conduct a “cost-benefit analysis, weighing how successful a particular policy might be in restraining the rise in asset prices versus how costly it would be to remain passive, letting the bubble grow and then potentially burst disruptively.”
Dudley said macroprudential tools could include “supervisory measures that set liquidity and capital requirements for financial institutions and other intermediaries,” and in the equity market, “margin rules for cash, options, futures and equity over-the-counter derivatives,” while in the fixed income market, it might mean, “raising the haircuts charged to securities dealers on their repo financing; raising the haircuts that the securities dealers assess against the collateralized borrowings of their customers as part of their prime brokerage business, or raising initial margin requirements on derivatives securities transactions.”
Of course, the last tool is monetary policy, but “monetary policy will not address specifically the sources of the changes in supply and demand that are driving the bubble and, obviously, monetary policy will have big effects elsewhere.”
He added, “Some argue that monetary policy should `lean against’ incipient asset bubbles. The notion is that by pursuing a slightly tighter monetary policy, the central bank would take out insurance against the risk that the rise in asset prices is a bubble and that its busting would be disruptive. Although this sounds attractive, it critically depends on how expensive the insurance is relative to the losses that the insurance protects against. It is not clear 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. 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. Historical experience does not suggest that bubbles are very sensitive to the level of short-term interest rates.”
