Excess Monetary Liquidity and Asset Prices

Abstract

The end of the internet bubble on equity markets and, more recently, the prolonged strength of house prices in most industrial countries, have brought questions about the role of monetary policy back to the fore. While management of the money supply has traditionally been aimed at preventing a resurgence in inflation, in the current context of price stability, the debate has shifted towards the supervision of asset prices. Several factors are commonly cited in connection with the notion of a liquidity effect on asset prices: an extended quantity equation of money including asset transactions; easy credit, which promotes purchasing and impacts prices; the direct role of interest rates in computing the fundamental value of assets; and expectations generated by current monetary policy, especially as reflected in low interest rates. This paper seeks to examine the extent to which these theories are germane and to assess whether, in practice, excess liquidity has had a discernable effect on equity and property prices in the euro area, the USA, the UK and Japan since the beginning of the 1980s. We demonstrate that liquidity, which is by definition an overall instrument of purchasing power, does not actually have an across-the-board effect on asset prices. On the contrary, individual asset price movements are bigger than the overall change in aggregate asset prices. Any econometric analysis of the linkage between asset prices and excess liquidity must factor in the possibility of feedback effects from asset prices to money. For this reason, we estimate VAR and VECM models to look at reciprocal interactions in the four geographical zones covered by the paper. It was impossible to clearly demonstrate the effects of excess liquidity on equity prices. The findings for property prices were more nuanced, especially in the case of the UK. However, even where an effect was detected, its impact was limited. Using the available data on France, we explore the notion of the quantity equation of money extended to assets, and measure its relevance. It turns out that adding property or securities transactions to transactions in goods and services does not stabilise the velocity of money. Thus we do not find support from traditional quantity theory for the idea of a transmission from monetary policy to asset prices. In sum, there is only tenuous evidence that excess liquidity affects asset prices. While speculative bubbles may have formed around equity and property prices, they did not wait for help from monetary policy to take shape. Note, however, that this paper was deliberately conducted within a linear setting. The findings do not therefore refute research demonstrating that beyond a certain threshold, excess liquidity represents a threat to financial stability.