Monetary policy is mainly about keeping unemployment and inflation low. But it would be nice if it could also be used to restrain asset price bubbles (because such bubbles invariably burst, causing severe financial crises and recessions). Given that during asset price bubbles people tend to feverishly buy assets with borrowed money, the central bank could simply slow its lending of newly printed money to banks and thereby cut off the bank lending fueling bubbles.
And yet, until the financial crisis of 2008, central bankers had been unwilling to take on the task of fighting asset price bubbles. Why? When asset prices start to rise, it is hard to know whether the rise in prices is sustainable or a bubble that is about to burst; by the time it is clear that a rise in asset prices is a bubble, it is usually too late. So, given that bubbles are hard to detect quickly, it was thought that instead of trying to stop bubbles from forming central banks should let them form, but move in quickly after they burst to make the inevitable recession as painless as possible (by implementing expansionary monetary policy to reduce interest rates and thereby stimulate the economy).
Unfortunately, the crisis of 2008 has shown that while detecting an asset price bubble in a timely manner may be hard, letting a bubble develop and cleaning up the mess after it bursts may be even harder.
So, should central banks set aside their hesitation about fighting bubbles, and restrict the money supply in order to raise interest rates whenever they see what looks like the beginnings of an asset price bubble? Not so fast; it is a hard trick to pull off. The Swedish central bank tried to do just that in 2010 but ended up creating a recession. "Before long, Sweden had succumbed to deflation, from which it is still struggling to recover."
The best approach may be to use the central bank's control over the interest rate for the traditional purpose of keeping unemployment and inflation low, and to develop separate tools to tackle asset price bubbles. The use of these separate tools is called macroprudential policy.
The two main tools of macroprudential policy are (procyclical) capital requirements and (countercyclical) loan-to-value ratios.
Capital Requirements: The money that a bank lends comes from its depositors (deposits), its lenders (debt), and its owners (capital). If the monetary authorities require banks to rely more on their owners' capital for the money they lend, the banks would tend to be more cautious about lending. Therefore, raising capital requirements during the initial stages of an asset price bubble may squelch bank lending to the crazed buyers driving up asset prices, and thereby stop a bubble from forming.
Loan-to-Value Ratios: Suppose you wish to buy a house and a bank lends you 95 percent of the value of the house, leaving you to pay only the remaining 5 percent. That would make buying a house easy. On the other hand, if the monetary authorities impose a loan-to-value ratio of 75 percent, the demand for houses would shrink. In this way a bubble in home prices can be avoided if the loan-to-value ratio is reduced when house prices start to rise in a bubble-like manner.
Unfortunately, although these macroprudential tools are fine in theory, they have problems of their own: "The Bank of Spain’s attempt to implement adjustable capital requirements for banks, ... did little to deter aggressive lending during the country’s property boom. Once a mania gets underway, the temptation to join is simply too strong." Also, discouraging banks from lending to home buyers by reducing loan-to-value ratios may simply encourage other unregulated lenders to step in and fill the gap.
So, where does all this leave us? Although the new macroprudential tools are imperfect, it is probably better to have more tools than less. The central bank can use its control over interest rates for the traditional purpose of keeping inflation and unemployment low, and it can use macroprudential policies to stop asset price bubbles from destabilizing the economy.
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