A new NBER paper reminds us of historical episodes when loose monetary policy contributed to asset price booms and busts. The paper also provides econometric evidence that low policy rates usually support asset prices. This history may not dissuade central banks from running highly accommodative policies at present, but explains the importance of accompanying macro-prudential measures.

“Does Expansionary Monetary Policy Cause Asset Price Booms; Some Historical and Empirical Evidence”
Michael D. Bordo and John Landon-Lane
NBER Working Paper No. 19585 Issued in October 2013

http://www.nber.org/papers/w19585.pdf

The below are excerpts from the paper. Cursive lines and emphasis have been added.

Loose monetary policy does contribute significantly to booms in house prices, commodity prices and somewhat less to booms in stock prices…We show that ‘loose’ monetary policy – that is having an interest rate below the target rate or having a growth rate of money above the target growth rate – does positively impact asset prices and this correspondence is heightened during periods when asset prices grew quickly and then subsequently suffered a significant correction. This result was robust across multiple asset prices and different specifications and was present even when we controlled for other alternative explanations such as low inflation or ‘easy’ credit.”

Brief history of key asset booms and busts related to easy monetary conditions

The 1840s [British] railroad mania was a precedent to the 1990s dot com boom. After the first successful railroad was established in 1830, optimistic expectations about potential profits that later turned out to be overly optimistic led to massive investment in rails and rolling stock, which extended the network across the country. The boom was accommodated by expansionary monetary policy in response to gold inflows. The end of the railroad boom was associated with the banking panic of 1847—one of the worst in British history. The crash, in which stock prices fell by 30% and the panic, as in earlier episodes, may have been triggered by tightening of the Bank of England’s monetary policy stance, reflecting its concern over declining gold reserves. The panic led to many bank failures and a serious recession.”

“The most famous episode of an asset price boom is the Wall Street Boom beginning in 1923 and ending with the Crash in October 1929.During the boom stock prices rose by over 200%, the collapse from 1929 to 1932 had prices decline by 66%.The boom was associated with massive investment that brought the major inventions of the late nineteenth century, e.g. electricity and the automobile, to fruition. In addition, major innovations also profoundly changed industrial organization and the financial sector, including the increased use of equity as a financial instrument. The economy of the 1920s (following the sharp recession of 1920-21) was characterized by rapid real growth, rapid productivity advance and slightly declining prices, punctuated by two minor recessions. Adolph Miller, a member of the Federal Reserve Board blamed the New York Fed and its President Benjamin Strong for pursuing expansionary open market purchases to help Britain restore the pound to its prewar parity in 1924 and then again in 1927 to protect sterling from a speculative attack. In both occasions, the U.S. economy was in recession justifying expansionary policy. Miller indicted Strong (who died in 1928) for fueling the stock market boom and the resultant crash. His views were instrumental in legislation in 1933 which prohibited Reserve banks from engaging in international monetary policy actions.”

The UK had a massive house price and stock market boom in 1971-1974, referred to by Tim Congdon (2005) as the Heath Barber Boom after the then Prime Minister and Chancellor of the Exchequer. Congdon documents the rapid growth in broad money (M4) after the passage of the Competition and Credit Control Bill in 1971 which liberalized the UK financial system and ended the rate setting cartel of the London clearing banks.”

“The Nordic countries, Norway, Sweden and Finland all experienced major asset booms and busts in the 1980s. In each country the run up in asset prices followed liberalization of their financial sectors after 5 decades of extensive controls on lending rates and government control over the sectoral allocation of bank lending. Asset booms were accommodated by expansionary monetary policy as each country adhered to pegged exchange rates which tended to make monetary policy pro-cyclical.”

“The Japanese boom-bust cycle began in the mid-1980s with a run up of real estate prices fueled by an increase in bank lending and easy monetary policy. The Bank of Japan began following a looser monetary policy after the Plaza Accord of 1985 to attempt to devalue the yen and ease the upward pressure on the dollar. The property price boom in turn led to a stock market boom as the increased value of property owned by firms raised future profits and hence stock prices. Both rising land prices and stock prices in turn increased firms’ collateral encouraging further bank loans and more fuel for the boom. The bust may have been triggered by the Bank of Japan’s pursuit of a tight monetary policy in 1989 to stem the asset market boom.”

“The 1994-2000 U.S. dot com stock market boom had many of the elements of the railroad boom in England in the 1840s and the 1920s Wall Street boom including rapid productivity growth and the dissemination and marketing of technologies that had been developed earlier… As in earlier booms, easy bank (and non-bank credit) finance was crucial, as well as accommodative monetary policy. As in the 1920s boom the question arose whether the rise in stock prices reflected underlying fundamentals (referred to as the “New Economy”) or a speculative bubble.”

Econometric evidence

“Using a panel of up to 18 OECD countries from 1920 to 2011 we estimate the impact that loose monetary policy, low inflation, and bank credit has on house, stock and commodity prices.”

“The definition of a boom that we use is that a boom is a sustained expansion in asset prices that ends in a significant correction. For an expansion to meet the definition of a sustained expansion the expansion must last at least two years and average at least 5% per year for real house and commodity prices and average at least 10% per year for real stock prices…the price correction that follows the expansion in prices must be greater than 25% of the expansion in price that occurred during the preceding expansion. We believe that this definition rules out secular trends where there can be large increases in asset prices followed by small corrections followed by another large expansion…Stock prices show considerably more volatility than house prices and many more booms and busts.”

Loose monetary policy refers to deliberately expansionary monetary policy as evidenced in the policy rate being below the Taylor rule rate, done for example to prevent deflation as in the 2000s or to stimulate recovery from a recession.”

“Our regression analysis then investigates the relationship between the deviation from the long run trend of asset prices and the deviation of short term interest rates from their long term trend and the deviation of the short term interest rate from the “optimal” Taylor rule rate… control variables such as credit conditions, the growth rate of real GDP, current account imbalances and a measure of financial liberalization are included into the regression equation.”

When the short term interest rate is below the optimal rate suggested by the Taylor rule…there is positive pressure on real house prices. This result is consistent even when we control for the interest rate (as measured as a deviation from its long-run trend) and other control variables described above.”

“The [impact of the] deviation of the interest rate from the optimal Taylor-rule rate [on real stock prices]…is not always significant and when it is, it has the wrong sign. [However] the results for the measure of the level of the interest rate (its deviation from its long-run mean) are much stronger… Thus when interest rates are low relative to their recent history (as opposed to low relative to the optimal Taylor-rule rate) there is a positive impact on stock prices.”

“For real commodity prices we find that loose US monetary policy significantly impacts commodity prices for some of the specifications. The coefficient on the policy variable is consistently negative but not always significant. We also find the low interest rates (at least lower than average) impact real commodity prices.”

Changing the traditional view of monetary policy

“The traditional view holds that monetary policy should react to asset price movements only to the extent that they provide information about future inflation. This view holds that monetary policy will contribute to financial stability by maintaining stability of the price level and that financial imbalances or crises should be dealt with separately by regulatory or lender of last resort policies.”

“The housing bust of 2006 in the U.S. and the subsequent financial crisis and Great Recession led many policy makers to decide that financial stability should be an important goal of central banks along with low inflation (and overall macro stability). The new view argued that central banks should be closely monitoring asset price developments and the state of the financial system (including non-banks and banks) and be willing to use policy to defuse threatening imbalances. This became known as the case for macro prudential regulation which promoted the use of policy tools such as countercyclical capital requirements and liquidity ratios.”

“This case, fostered by the BIS and many others, has led to important changes in the central banking and financial regulatory landscape including the 2010 Dodd Frank Bill in the U.S. which has given the Federal Reserve greatly expanded powers over the financial system as a whole, and in the UK where the Bank of England has taken over the responsibilities of the Financial Stability authority.”