Coming to my second question, how should central banks react if they see the risk of an emerging asset price bubble? The options range from not reacting at all to consciously trying to prick an emerging bubble. Obviously, attempts to deflate an asset price bubbles are likely to require substantial interest rate increases which, in turn, could adversely affect economic activity and inflation. In view of the difficulties in identifying a bubble, it seems established wisdom today that central banks should be exceedingly careful in dealing with asset bubbles. There is, however, a more subtle way: to cautiously consider “leaning against the wind” when an asset price bubble is developing. Indeed, some academics have argued that, by accepting some short-term deviation from the pursuit of its stated objective of price stability, a central bank may improve the conditions for maintaining price stability over the medium to long-term. If a potentially costly bubble is firmly under way, then a somewhat tighter monetary policy stance than would otherwise be needed could be warranted. Certainly, there are also risks involved in “leaning against the wind”. First, as I mentioned already, there can never be full certainty as to whether an asset price bubble is under way. Second, by influencing market psychology, a monetary policy tightening could trigger dynamics that are difficult to foresee and may be hard to control ex post. Effective communication, as always, is crucial, especially in situations of heightened uncertainty.
The central bank can consider adjusting its communication pre-emptively in order to discourage the formation of overly optimistic expectations regarding future returns and/or in order to signal concerns about too low risk premia. In any case, monetary authorities, through their communication, should avoid appearing complacent, thus possibly contributing themselves to unrealistic expectations and asset-price dynamics that are not in line with fundamentals. Finally, central banks should not be seen as reacting asymmetrically to asset price movements; that is, as only reacting to mitigate the consequences of a fall in asset prices. Obviously, such asymmetric behaviour can lead to moral hazard in the market, with the central bank becoming a potential contributor to excessive asset price fluctuations, if its actions induce private agents to take higher risks than would otherwise be the case. What is the situation in the euro area housing and equity markets? After these rather general considerations, let us look at the current situation in the euro area? What are the underlying factors fuelling recent developments in asset prices? Are these developments a cause for concern and what are the associated risks? Let me first focus on residential property markets. As already noted, growth rates in euro area property prices have been rather dynamic in recent years. After relatively modest price increases of less than 3% between 1993 and 1998, residential property prices on average for the euro area as a whole have been rising at annual rates of around 6-7% in each of the past four years.