The role of the European Central Bank (ECB) is a lively and heatedly debated topic in the public and in politics. The questions are whether and how the ECB should actively play role and take measures to avoid a crisis like the one the European Union has been experiencing. Leading up to the economic and financial crisis of 2008-2009, many countries were enjoying a real-estate boom, which was followed by a rapid decline in housing prices. Before the bust, the consensus seemed that central banks should focus on inflation targets and the output gap, while ignoring potential bubbles. Now voices are emerging that call for central banks to “lean against the wind,” meaning they should raise interest rates to counteract asset price inflation. This is demanded even under consideration of the cost of temporary deviations from inflation or output gap targets.

In a recent Barcelona Graduate School of Economics working paper (No. 724) (December 2013), Jordi Galí and Luca Gambetti provide evidence on the response of stock prices to sudden and considerable changes in monetary policy, so called shocks, and try to use that evidence to infer the nature of the impact of interest rate changes on the bubble component of stock prices.

Monetary policy and asset price bubbles: theoretical issues

The starting point of the investigation is an estimated vector-autoregression (VAR) on quarterly US data from 1960 to 2011 for GDP, inflation, dividends, the federal funds rate, and a stock price index (S&P500). The identification of monetary policy shocks is based on the approach of Christiano, Eichenbaum, and Evans (2005). The price of an asset is assumed to be composed of two components. First, a “fundamental” component, which is the present discounted value of future dividends and is assumed to decline in response to an exogenous tightening of monetary policy. Second, a bubble component, which under the “conventional view” declines in size as a response to monetary tightening as well. According to the findings of Galí (2013), this does not have a clear theoretical underpinning. Instead, economic theory indicates that in equilibrium the expected growth rate of the bubble equals the interest rate (under risk neutrality).

Empirical analysis

In the empirical investigation the authors assume that a monetary policy shock does not affect GDP, dividends, or inflation contemporaneously. The tightening of monetary policy, meaning an increase in interest rates, is found to lead to a persistent increase in both nominal and real rates, and an accompanying decline in dividends. The stock price index also declines in the short run, though, subsequently recovering and ending up in slightly positive territory. The authors detect a substantial and growing difference between the response of the stock and that of the fundamental component of stock prices to a monetary policy shock. They interpret that evidence as being consistent with the existence of a bubble whose growth is increasing in the interest rate.

More specifically, the S&P500 is shown to generally decline on impact, often substantially, in response to monetary policy tightening. Until the late 1970s, consistent with the response of stock prices in the absence of a bubble, that decline is persistent. By contrast, starting in the early 1980s, the initial decline is rapidly reversed with stock prices rising quickly (and seemingly permanently) above their initial value. That phenomenon is particularly acute in the 1980 and 1990s. Except for in the early part of the sample the gap between observed and fundamental stock prices appears to be positive and growing as put forth by the theory of rational bubbles, and in contrast to the “conventional view”. The estimated probability of the gap being positive is well above 50 percent as of the mid 80’s.

Given the provided evidence that a rise in interest rates can increase bubbles, the authors call for further research on the effects of monetary policy on asset price bubbles before one starts thinking about how monetary policy should respond to asset prices.

References

Galí, Jordi. “Monetary Policy and Rational Asset Price Bubbles.” American Economic Review, 104(3), 721-52.

Christiano, Lawrence J., Martin Eichenbaum, and Charles L. Evans. “Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy.” Journal of Political Economy, 113(1), 1-45, 2005.