Monetary Policy, Market Excesses and Financial Turmoil

Abstract

This paper addresses the question of whether and how monetary policy ease may lead to excesses in financial and real asset markets and ultimately result in financial dislocation. It presents evidence suggesting that periods when short-term interest rates have been persistently and significantly below what Taylor rules would prescribe are correlated with increases in asset prices, especially as regards housing, though no systematic effects are identified on equity markets. Significant asset price increases, however, can also occur when interest rates are in line with Taylor rules, associated with periods of financial deregulation and/or innovation. The paper argues that accommodating monetary policy over the period 2002-2005, in combination with rapid financial market innovation, would seem in retrospect to have been among the factors behind the run-up in asset prices and consequent financial imbalances - the (partial) unwinding of which helped trigger the 2007 financial market turmoil. Moreover, the paper points out that in certain situations policy rates may be a rather blunt tool for dealing with both the build-up and aftermath of financial imbalances, raising the question whether "macro-prudential" regulation could be useful.

Keywords: interest rates, monetary policy, housing, sub-prime crisis, financial markets, macro-prudential regulation, Taylor rule, house prices, asset prices, financial imbalances, market turmoil, financial innovation

JEL Classification: E44, E5, F3, G15