The Federal Reserve, the US central bank, is buying assets from the marketplace at the pace of $85 billion per month with an objective of keeping interest rates low and bringing down the level of unemployment in the country to 6.5%. The level of unemployment currently stands at 7.5%. Concerns have been expressed time and again from various quarters that this massive market intervention by the Federal Reserve will fuel asset price bubbles. Stocks, for example, in the US are at an all-time high despite weakness in the economy. Although the current level of stock prices is difficult to term as a bubble, the concerns around the rise in asset prices have reached the doorstep of the Federal Reserve. In an address in Chicago on 10 May, Ben S. Bernanke, the chairman of the Federal Reserve, noted: “In light of the current low interest rate environment, we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.” Put differently, the US central bank is now getting worried about the build up in asset prices.
What is asset price bubble?
Asset price bubble is a state when the price of an asset goes up rapidly in a short span of time and is not supported by the fundamentals. This can happen in stocks, commodities or land and housing. Interestingly, the first known financial bubble was formed in the prices of tulip bulbs in Holland in the early 17th century, better known as tulip mania. A 2013 International Monetary Fund working paper notes that at the peak of the bubble, a single bulb was sold at an equivalent of $60,000 in today’s dollars, which works out to Rs.33 lakh. Clearly, prices lost all possible linkages to the fundamentals. There have been a number of asset price bubbles in history since the tulip mania such as the rise in stock prices in the US in 1920s, the Internet bubble, the stocks and real estate prices bubble of 1980s in Japan and the latest housing price bubble in the US and other parts of the developed world.
Reasons and cure
The reason for asset price bubble is excessive speculation or “irrational exuberance” on the part of the investors. The speculative bubble is normally backed by new-found stories and theories trying to prove that “this time is different”.
Should central banks use the monetary policy to check asset prices in case a bubble is formed in the financial market is being debated. While the jury is still out, one thing is clear that the central banks should not ignore asset price, especially when it is not in sync with the underlying fundamentals.
Investors are always better off participating in an asset till the time it is supported by the fundamentals.