Should central banks be concerned about fluctuations in asset prices? If so, how should monetary policy be used to tame fluctuations?

These questions were brought to the fore by the dot-com bust of 2001 and became even more urgent after the 2007–09 Great Recession. But while most observers agree that there are significant links between financial markets and the real economy, it remains an open question whether policymakers should take pre-emptive actions to deflate bubbles.

Marco Airaudo believes they should. In a paper under review with the Journal of Money, Credit and Banking, he argues that the Federal Reserve should intervene in asset and stock market bubbles by raising the federal funds rate. This would stabilize the economy by moderating large swings in stock and asset prices.

Part of his argument hinges on the expectations of agents in the market — if agents anticipate asset price appreciation, their beliefs may be sufficient to drive up market prices even if their expectations have no basis in economic fundamentals (new patents, breakthrough technologies, government stimulus, etc.).

The Fed can use the federal funds rate to prevent asset price bubbles in a number of ways, Airaudo argues. First, it can lower the discounted value of future expected cash flows and therefore control the current asset price surge. Second, by making the cost of money higher, it can slow down the demand for credit (corporate loans, mortgages, etc…) which is often used to finance asset purchases (in particular, real estate), thus bringing down their asset prices. Third, these actions would deflate the expected resale value of the asset itself, thus dragging down the current price, too.

Has the Fed followed this policy before the 2007–09 financial meltdown? A review of empirical studies by Airaudo suggests that it did not. “Not surprisingly, following the double-digit inflation rates of the ’70s and early ’80s, in the post-Volcker era, changes in the federal funds rate have been mainly dictated by the Fed’s concern for inflation stabilization,” says Airaudo.