484 PA R T V Central Banking and the Conduct of Monetary Policy raising interest rates can diminish rises in asset prices, raising interest rates may be very ineffective in restraining the bubble, because market participants expect such high rates of return from buying bubble-driven assets Furthermore, raising interest rates has often been found to cause a bubble to burst more severely, thereby increasing the damage to the economy Another way of saying this is that bubbles are departures from normal behaviour, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions Second, there are many different asset prices, and at any one time a bubble may be present in only a fraction of assets Monetary policy actions are a very blunt instrument in such cases, as such actions would be likely to affect asset prices in general, rather than the specific assets that are experiencing a bubble Third, monetary policy actions to prick bubbles can have harmful effects on the aggregate economy If interest rates are raised significantly to curtail a bubble, the economy will slow, people will be thrown out of work, and inflation can fall below its desirable level Indeed, as the first two arguments suggest, the rise in interest rates necessary to prick a bubble may be so high that it can only be done at great cost to workers and the economy This is not to say that monetary policy should not respond to asset prices per se As we will see in Chapter 25, the level of asset prices does affect aggregate demand and thus the evolution of the economy Monetary policy should react to fluctuations in asset prices to the extent that they affect inflation and economic activity Although it is controversial, the basic conclusion from the above reasoning is that monetary policy should not be used to prick bubbles Are Other Types of Policy Responses Appropriate? As argued above, there is a case for responding to credit-driven bubbles because they are more identifiable and can great damage to the economy, but monetary policy does not seem to be the way to it Regulatory policy to affect what is happening in credit markets in the aggregate, referred to as macroprudential regulation, on the other hand, does seem to be the right tool for the job of reining in credit-driven bubbles Financial regulation and supervision, either by central banks or other government entities which have the usual elements of a well-functioning prudential regulatory and supervisory system described in Chapter 10, can prevent excessive risk-taking that can trigger a credit boom, which in turn leads to an asset-price bubble These elements include adequate disclosure and capital requirements, prompt corrective action, close monitoring of financial institutions risk-management procedures, and close supervision to enforce compliance with regulations More generally, regulation should focus on preventing future feedback loops from credit booms to asset prices, asset prices to credit booms, and so on As the subprime financial crisis in the United States demonstrated, the rise in asset prices that accompanied the credit boom resulted in higher capital buffers at financial institutions, supporting further lending in the context of unchanging capital requirements; in the bust, the value of the capital dropped precipitously, leading to a cut in lending Capital requirements that are countercyclical, that is, adjusted upward during a boom and downward during a bust, might help eliminate the pernicious feedback loops that promote credit-driven bubbles A rapid rise in asset prices accompanied by a credit boom provides a signal that market failures or poor financial regulation and supervision might be causing a bubble to form Central banks and other government regulators could then consider implementing policies to rein in credit growth directly or implement measures to make sure credit standards are sufficiently high