A rapid rise in private sector borrowing can give advance warning of hard-to-spot asset price bubbles and enabling central banks to take pre-emptive action, according to European Central Bank research.
Policymakers should not try to target asset prices directly or risk the unpredictable effects of pricking a large bubble but could consider a gentle tightening of monetary policy in the early stages of a bubble, said the article in the ECB's Monthly Bulletinreleased today.
"This approach amounts to a cautious policy of 'leaning against the wind' of an incipient bubble," it said.
"The central bank would adopt a somewhat tighter policy stance in the face of an inflating asset market than it would otherwise allow."
House price crashes cost an average 8 per cent of an affected region's gross domestic product; share price busts cost 4 per cent, the report said.
"A deflating bubble in the housing market is more costly than an equally-sized crash in the stock market, as housing equity is more widespread and more intensely used as collateral for securing credit," it said.
Spotting bubbles in their early stages is difficult, as it is often subjective whether an asset is overpriced or not. But the report said that rapidly rising private-sector borrowing acted as an early, more clear-cut, signal.
"The volume of aggregate credit demonstrates a fairly systematic leading relationship with episodes of asset price turbulence." Often it is only later that the impact spreads to inflation.