Geneva Report on the World Economy No. 2

Asset Prices and Central Bank Policy

by

Stephen G. Cecchetti, Hans Genberg, John Lipsky and Sushil Wadhwani

Executive Summary

How should centrals banks view movements in equity, housing and foreign exchange markets?  Developments in asset markets can have a significant impact on the both inflation and real economic activity.  History is replete with examples in which large swings in stock, housing and exchange rate markets coincided with prolonged booms and busts. It is important to ask whether there are any actions central banks can and should take to minimize the likelihood of macroeconomic instability arising from extreme changes in asset prices.

With these issues in mind, we address a series of specific questions.  First, in formulating day-to-day policies, can policy makers improve macroeconomic performance by giving consideration to movements in asset prices? Or, as many influential economists argue, should monetary policy makers ignore asset price changes and set interest rates in response only to forecasted future inflation, and possibly to the output gap as well?   

Our answer is that a central bank concerned in stabilizing inflation about a specific target level is likely to achieve superior performance by adjusting its policy instruments not only in response to its forecast of future inflation and the output gap, but to asset prices as well.  This conclusion is based in part on our view that reaction to asset prices in the normal course of policy making will reduce the likelihood of asset price misalignments coming about in the first place. Also, inflation forecasts depend on assumptions about asset prices that, in turn, must depend on views about the size of asset price misalignments. We are not recommending that central banks seek to burst bubbles they currently perceive to exist, nor do we suggest that they target specific levels of asset prices.  Furthermore, we do not recommend responding to all changes in asset prices in the same way.  The response to a rise in equity prices driven by higher productivity growth would be very different from the appropriate reaction to an asset price misalignment or bubble.

A central bank that reacts to asset price changes must attempt to estimate misalignments. It has been claimed that the pitfalls involved in doing so makes our proposal impractical. Our response is that the difficulties associated with measuring asset price misalignments are not substantially different from those of estimating theoretical constructs such potential GDP or the equilibrium real interest rate. These difficulties have rightly not prevented central banks from using these concepts in the course of deciding on monetary policy. Similarly, although asset price misalignments are difficult to measure, this should be no reason to ignore them.

This being said, there will always be a great deal of imprecision in estimates of these misalignments, as there is in estimates of other key macroeconomic quantities that are crucial in setting interest rate instruments.  As a result, it is important for central bankers to develop a framework for policy making that accounts for the various sources of uncertainty that they face in setting their instrument to meet their inflation and growth objectives.

Are there alternative, less conventional, policy responses for addressing perceived asset price misalignments?  The historical record is filled with attempts by policy makers to move equity prices and exchange rates.  The U.S. experience in 1929 where the Federal Reserve opposed bank lending collateralized by stock is a clear example. We examine this case, as well as attempts to rely on public statements to move asset prices or to use margin requirements to reduce their volatility, and conclude that these strategies are generally ineffective.

Should asset prices be included directly in measures of inflation?  For many years, some economists have argued that a properly constructed inflation index should be based on both the prices of what is currently consumed, as conventional consumer price indices are today, and prices of future goods and services, as represented by the price of assets.  Proponents of this view suggest that monetary policy should seek to stabilize such a combined index. 

There are reasons to be skeptical of the arguments for such an inflation index, as no one has yet provided an analysis why focusing on such a measure of prices reduces the cost of inflation most effectively.   Furthermore, most common implementations of this proposal places a very high weight on asset prices, and amounts to suggesting that central banks target asset rather than current consumption prices.  We provide an alternative set of calculations based on the idea that inflation affects all nominal prices, including equity and housing.  Our conclusion is that changes in stock prices are much to noisy to be useful in inflation measurement, but that prices of homes contain significant useful information.

Finally, we ask whether asset prices can be used to improve forecasts of future inflation.  Many studies show a relationship between retail price inflation and movements in equity prices, housing prices and exchange rates.  We survey this evidence, and add a few calculations of our own.  Overall, the results suggest that asset prices have a strong effect on future inflation, although the impact surely differs across countries and may shift over time.

To obtain a copy of the full report, please contact www.cepr.org