Fed and asset prices

Is ultra-loose monetary policy fuelling new asset price bubbles? The Fed view is that there is little evidence of this in the US. But it is keeping an eye out all the same.

US house prices may have bottomed but they have not bounced. The equity risk premium on stocks remains high by historic standards. Commodity price strength can be explained by vigour in emerging economies.

The government bond market is a possible exception. In their last minutes Fed policymakers said they were puzzled by bond prices. There could be something of a bubble here, fuelled by Fed asset purchases and banks playing the yield curve. And its deflation could be disruptive. But in general – no great alarm about asset prices.

Indeed the Fed wanted asset prices to rally, up to a point, as part of the transmission mechanism by which monetary policy impacts the economy. Still, after the experience of the past couple of years the Fed is not ignoring asset prices and continues to monitor them carefully.

The US central bank hopes in future to deal with asset and credit bubbles via new regulatory tools, including systemic risk or macroprudential instruments rather than interest rates. But by and large these tools do not exist yet. So if compelling evidence of asset price bubbles were to emerge in the interim the Fed would have to consider whether to lean against the wind with interest rates. I think in certain circumstances policymakers could be open to that.

The more imminent risk, though, surely is that ultra-easy policy in the US, eurozone, UK and Japan helps to fuel asset price bubbles in emerging market such as China, Brazil and India – and small industrialised economies that largely escaped the crisis such as Australia.

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