To Lean or Not to Lean Against an Asset Price Bubble? Empirical Evidence

Abstract

Since the Global Financial Crisis of 2007–2009, economists are reconsidering the appropriate role of monetary policy towards equity bubbles. This paper contributes to these deliberations by estimating the response of the stock market to monetary policy tightening by using a Bayesian time‐varying VAR model. By introducing the cyclically adjusted price/earnings ratio, we propose a method that estimates its fundamental and bubble components. We find that asset prices will initially fall and eventually rise again but without the risk of feeding the bubble. Counterfactual policy experiments provide additional evidence that monetary policy can lean against equity and housing prices. (JEL E50, E52, E58)

Monetary policy, financial shocks and economic activity

“…Figure 8 shows the actual data (black line) and the results of our counterfactual experiment for IP, inflation, unemployment rate, CAPE, credit to households and credit to the non-financial sector (red lines). The results, consistent with Evgenidis and Malliaris ( 2020 ), suggest that leaning against the build-up of financial imbalances helps to moderate the increase in asset prices as well as credit growth in the period before the crisis (note the reduction in the counterfactual values of CAPE, credit to households and credit to non-financial sector, compared to their actual data). Additionally, although the counterfactual path of unemployment falls from 2003 to 2005, it starts rising thereafter to levels above the actual rate.…”

“…Instead of reconsidering the policy “do not lean against a bubble”, a new policy was gradually formulated that proposed to “clean after the bubble bursts”. Mishkin ( 2011 ), Malliaris ( 2012 ), Evanoff et al ( 2012 ) and recently Evgenidis and Malliaris ( 2020 ) give an extensive bibliographical overview of this debate and explain that the views held prior to the Global Financial Crisis of 2007–2008 favored the “clean” choice. Some key arguments for this choice and against the leaning approach included: First, strictly speaking the Fed’s dual mandate does not include management of asset bubbles.…”

“…output and inflation stability, versus addressing risks to financial stability thus reducing the probability of a recession. This challenge of the central bank is explored in detail in Evgenidis and Malliaris ( 2020 ) and Bhar and Malliaris ( 2021 ). In this paper, we propose that policy makers need to consider business cycle phases when they design monetary policy.…”

Monetary policy, financial shocks and economic activity

“…output and inflation stability, versus addressing risks to financial stability thus reducing the probability of a recession. This challenge of the central bank is explored in detail in Evgenidis and Malliaris (2020) and Bhar and Malliaris (2021). In this paper, we propose that policy makers need to consider business cycle phases when they design monetary policy.…”

Unconventional Monetary Policy and Wealth Inequalities in Great Britain*

“…40 40 A similar experiment has been recently adopted by Evgenidis and Malliaris (2020) to examine the recent impact of QE on asset prices in the US. …”