When discussing asset bubbles in my course on central banking and monetary policy, I pose two questions: (1) should central banks respond to bubbles and (2) should monetary policy be used to prick such bubbles? In both cases, the answer is no.
To understand why, we can look at the credit-driven, US housing bubble burst in 2006, that contributed to causing the 2008 recession. Credit-driven asset bubbles are market conditions in which a specific type of asset experiences increasing prices that depart from fundamental values.
Following the dot-com bubble burst of the year 2000 and the mild recession of 2001 (which concluded a 2-year period of stagnating growth - figure 1), the Federal Reserve maintained an expansionary monetary policy stance that achieved a very low Effective Funds Rate: about 1% between 2003 and 2004 (figure 2).
Figure 1 - Real Gross Domestic Product (GDPC1)
Figure 2 - Effective Federal Funds Rate (DFF)
At the same time, core inflation was displaying a decreasing trend (between the end of 2001 and the end of 2003 - figure 3) which never required a reversal of the existing monetary policy stance.
Figure 3 - Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average (CPILFESL)
Incentivised by low interest rates, private residential fixed investments (investment in housing) increased, from mid 2002, at a rate higher than in the 10 years before the 2001 recession (figure 4).
Figure 4 - Private Residential Fixed Investment (PRFI)
As demand for houses increased at a rate faster than supply, housing prices started to increase, fuelled by easy credit conditions. In some areas they increased very quickly (figure 5). The ever-increasing house prices were providing to lenders the false guarantee that future market values would have kept intact the quality of the collateral for the mortgages. In such conditions, government entities such as Fannie Mae and Freddi Mac guaranteed mortgages even to subprime borrowers, who would have not qualified for loans in different market conditions.
Figure 5 - All-Transactions House Price Index for Florida (FLSTHPI)
In some areas, however, prices did not increase that dramatically (figure 6).
Figure 6 - All-Transactions House Price Index for Austin-Round Rock-Georgetown, TX (MSA)
When inflation started to increase, in January 2004 (figure 3), the Federal Reserve reacted with a tightening of its monetary policy and the Fed Funds Rate Target increased continuously from mid 2004 to mid 2006 (figure 2). As a consequence, the rate of growth of residential fixed investment decreased at the end of 2005 and became negative in early 2006 (until the end of 2010 - figure 4). Housing prices declined dramatically therefore deflating the bubble (figure 5).
Meanwhile, the financial industry had heavily invested in mortgage-backed securities (MBS) and derivatives (such as the Collateralised Debt Obligations - CDO). Once the market prices of the collaterals (the houses) steeply declined, the value of mortgages and of the MBS collapsed, driving the balance sheet of many banks towards illiquidity, if not straight into insolvency. The downturn in the housing market had just become a financial crisis, causing the 2008 recession.
Now back to the original questions: what could, or should, the Federal Reserve have done?
Firstly, bubbles are difficult to detect. Even the definition (asset prices departing from fundamental values) does not provide clear criteria to tell a genuine bubble from a simple shift in market dynamics, related perhaps to an external shock. In addition, different trends may coexsist at the same time, within the same market; for example, in the case of the US housing bubble, some locations experienced a dramatic increase in prices, others did not (figure 5 and 6).
Secondly, central banks are not in the privileged position they appear to be in; they do not have more information or insight than other market paricipants, so they are unable to detect bubbles and to identify their nature.
Thirdly, even if a bubble was detectable, central banks could only deploy a contractionary monetary policy by increasing the base rate (the Fed Funds Rate Target in the US). However, such a policy would negatively affect investments (and, only later, prices) across the entire economy, not just in the sector in which, allegedly, a bubble is inflating.
To answer the original questions, central banks should not respond to asset bubbles as they are not in a better position than other market participants to detect them and, even if they were able to, monetary policy should not be used to prick them without negatively affecting the entire economy.