Crisis prevention – the role of monetary policy… In recent years, perhaps the most influential view of how monetary policy should respond to a rapid increase in the price of an asset, and a possible associated credit expansion, can be described as follows. Let us, for simplicity, say that we are talking about an increase in house prices that has gone hand in hand with a substantial increase in household indebtedness. Monetary policy should only respond to a rapid increase in house prices and borrowing if the central bank’s forecasts indicate that it will lead to problems such as overheating and excessively high inflation. If this is not the case, the central bank should wait and see, but be prepared to quickly ease monetary policy if the housing market were to collapse and demand in the economy were to fall drastically. The main argument for such an “asymmetric” response would be that central banks are not especially good judges of whether there actually is an asset bubble or not. The fact that bubbles are difficult to identify is of course true. Nevertheless, house prices and borrowing can in some cases rise so quickly and by so much that it is difficult for policymakers to remain entirely passive – even if it is not possible to ascertain that there is a bubble building up. If a severe downward adjustment in house prices were to occur later on, it is probable that monetary policy would receive much of the blame for having been too passive earlier.
Essentially, it all comes down to a choice between two alternatives. On the one hand, central banks can try to slow down a worryingly rapid price rise in the housing market by keeping interest rates higher than they otherwise would have been. The obvious risk is that if increasing prices actually are driven by fundamentals, then an incorrect assessment has  2  BIS Review 134/2008  been made and demand in the economy will be subdued unnecessarily. But if the assessment was correct, a rapid downward correction in house prices may be avoided, or at least mitigated, as well as a subsequent fall in demand. On the other hand, central banks can disregard the fears and refrain from raising the interest rate. If price increases in this case are due to fundamentals a needless slow down in demand will be avoided. But if prices are due, for instance, to over-optimism among households and lenders, then severe problems may occur in the future when there is a rapid downward adjustment of house prices and a subsequent fall in demand and inflation. Which of the two alternatives is preferable can always be discussed, and may quite likely vary from case to case. However, it is far from obvious that the best choice is always to wait and see when facing a rapid increase in the price of houses or some other asset.