How Loose Monetary Policies by Central Banks Create Asset Bubbles and Lead to Inflation

Loose or Tight Monetary Policies ?

The debate over whether central banks around the world must pursue loose monetary policies or tight monetary policies has become sharp in the aftermath of the global financial crisis. Loose monetary policy refers to the practice of central banks keeping interest rates low, stimulating the economy as banks would lend more with low interest rates, and consumers would borrow more in this model. Whenever consumers borrow more and spend more on either new projects or pure consumption, the economy grows as the resultant spending by the consumers stimulates sales and improves the growth prospects of companies and businesses.

In other words, if the interest rates were low, then the consumers would have an incentive to spend, as keeping money in the bank is not an attractive option because the rate of interest is unattractive. This is the key reasoning behind central banks keeping interest rates low in the build up to the economic crisis and its aftermath.

The downside of keeping interest rates low is that more money would chasing the same or fewer amount of the goods and hence, the demand for goods and services would go up leading to inflation and price rise. This is the reasoning behind the counter argument against central banks keeping interest rates low.

Downsides of Loose Monetary Policies

The other downside of keeping interest rates low is that the excess liquidity goes into purchasing houses, assets, and other capital investment. This creates a situation where the excess money goes into buying up assets and hence, leads to creation of asset bubbles. This is what happened between 2001-2008 in the US and in Europe where the central banks kept the interest rates at close to zero thereby making investors take reckless bets and consumers taking on more mortgages and other loans that they could not possibly repay.

Further, the fact that the US Federal Reserve has continued its bond-buying program wherein it purchases the US Sovereign bonds outright has also led to inflation and the creation of asset bubbles.

Apart from this, when the Fed monetizes the debt and assets, it means that it is releasing liquidity into the system that creates more bubbles without solving the problem of the existing asset bubbles. This is the situation in most parts of the world where central banks with their loose monetary policies have instead of stimulating growth have contributed to the worsening of the macroeconomic situation.

The Exceptional Case of India

Of course, India is an exception to this trend where despite political pressure on the Reserve Bank of India or RBI, has resisted the pressure to lower interest rates.

The reasoning given by the RBI is that the inflation is too high in the country for it to lower rates and hence, it is pursuing a tight monetary policy.

However, the fact that growth has to be stimulated in the country where the stellar growth of the earlier years has come down to low levels means that there is going to be a lot of pressure on the RBI from all stakeholders to lower interest rates.

The point here is that the dilemma of stimulating growth at the expense of inflation means that central bankers have to walk a tightrope between lowering interest rates and risking inflationary pressures. This is the bottom line that the central bankers all over the world have been grappling with ever since the dotcom bubble burst in 2001. This has become more pronounced in the aftermath of the 2008 global economic crisis as the crisis is directly linked to the Fed’s actions in the buildup to the crisis.

Closing Thoughts

Finally, the best way to resolve this dilemma is to return the global economy to a gold standard wherein currency is backed by gold or other precious metals and hence, central banks cannot print money at will. This topic would be explored in detail in subsequent articles.