Yet ultra cheap borrowing costs are stoking asset prices – including Australian and Canadian residential property – near-record stock prices on Wall Street and riskier high-yield bonds.

So central banks and financial regulators are opting for so-called "macroprudential" measures, such as tighter lending restrictions and higher bank capital, to avoid dangerous bubbles blowing up the financial system.

The RBA and Australian Prudential Regulation Authority have tried to limit on loans to investors and foreign buyers to ease the frenzy in the Sydney and Melbourne property markets. But so far those measures have failed to prevent runaway price growth.

Monetary policy's one big advantage

Former US Federal Reserve governor Jeremy Stein warned four years ago that monetary policy was not always the perfect tool, but it has one big advantage over supervision and regulation.

Former Federal Reserve chairman Alan Greenspan. AP

"Namely that it gets in all of the cracks," Stein said.

"To the extent that market rates exert an influence on risk appetite...changes in rates may reach into corners of the market that supervision and regulation cannot."


In other words, clever financial market participants, including lightly regulated non-bank lenders and borrowers, can dodge rules.

In Washington, an Australian economist at the International Monetary Fund, Bradley Jones, has written a detailed account of the "lean versus clean" debate (Basel consensus v the defunct Jackson Hole consensus) on whether monetary policy should counteract asset bubbles.

US Federal Reserve chair Janet Yellen said soon after the crisis, "now that we face the tangible and tragic consequences of the bursting of the bubble, I think it is time to take another look". Bloomberg

Should policy makers confine their management of asset price cycles to cleaning up the after effect of any bursting of bubbles or should they lean against asset price booms at the risk of prematurely curtailing economic expansions?

The trouble with bubbles

Fed chair Alan Greenspan famously said before the 2008 financial crisis there was a "fundamental problem with market intervention to prick a bubble: it presumes that you know more than the market".

Similarly in 2002, his successor Ben Bernanke cautioned against the Fed trying to "substitute its judgments for those of the market."

"We cannot practice safe popping, at least not with the blunt tool of monetary policy," Bernanke said.


Bernanke was informed by his study of the Great Depression of 1929. He argued that, contrary to popular belief, an overzealous tightening of interest rates to counteract surging stock prices caused the economy to slow and stock market to crash.

Yet after the 2008 financial crisis policymakers have changed their minds.

The IMF's Jones writes in his 2015 paper that the devastating aftermath of the US housing and stock market crashes resolved the "clean versus lean" debate in favour of the latter.

Long term payoff

His thesis argues that the long-term welfare costs associated with allowing debt-driven asset price booms to grow unchecked can greatly exceed the short-term opportunity costs of slightly slower economic growth associated with pre-emptive intervention.

He notes that where the supply of goods is more price responsive than the supply of financial assets (such as inner Sydney housing, which seems in relatively short supply), excessive focus on the stability of goods-based inflation can contribute to inflating financial asset prices.

Second, he says that though long-term price stability should remain a primary objective of monetary policy, it is not a sufficient condition to insure against financial and economic instability.

Though bubbles may be hard for regulators to accurately identify, "constructing a range of plausible estimates of long-run fundamental value for asset prices, while inherently difficult, may be no more so than compiling a range of estimates of the natural rate of interest or unemployment," he notes.


Philip Lowe ahead of his time

Indeed, the now RBA governor Philip Lowe was ahead of his time on this ideology, co-writing a Bank for International Settlements paper in 2002 that argued – controversially at the time – that central banks should sometimes lean against asset bubbles and rapid credit expansions.

"Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability," Lowe co-wrote.

Today Lowe appears reluctant to apply his words of wisdom to the situation he presides over in Australia, conscious that inflation is subdued and the labour market is unexceptional.

Notably, Fed chair Janet Yellen said soon after the crisis, "now that we face the tangible and tragic consequences of the bursting of the bubble, I think it is time to take another look".

She has since opined that monetary policy faces "significant limitations" to promote financial stability, so macroprudential approaches to supervision and regulation needs to play the primary role.

"But experience with such tools remains limited, and we have much to learn to use these measures effectively," Yellen said in 2014.

The key message for policymakers is that highly targeted macroprudential measures are a useful first line of defence to avoid the nasty hangover of asset price bubbles.

But ultimately higher interest rates may be needed to get into the cracks when regulation cannot stop surging asset values like in Australia now.