RDP 9513: Asset-price Bubbles and Monetary Policy 1. Introduction

Financial market volatility is a topic of much contemporary interest. One reason for this interest is the world-wide move to financial deregulation in the 1980s and the associated rise in gross flows in the world's financial markets. Together, these imply a larger role for financial markets in the behaviour of the wider economy.

Interest in financial market volatility has also been heightened, however, because from time to time, asset markets behave in ways that most people find inexplicable. The signal recent example is the 1987 stockmarket crash when, despite the absence of any obvious news, the Dow Jones Industrial Average fell by 22 per cent on 19 October 1987, triggering stockmarket crashes around the world.

Of course if everyone believed in the efficient markets hypothesis, financial market volatility would not be very interesting. If we were confident that asset prices efficiently incorporated all public information about economic fundamentals, then financial market volatility would be for good reason and should not be a cause for concern. In this case, volatile asset prices would simply reflect volatile economic fundamentals.

This paper is concerned with the relationship between asset price volatility and the volatility of a key economic fundamental: inflation. The focus is on bond and foreign exchange markets and on the changes in volatility in these markets that occurred as inflation around the world fell and became less variable.

Economic theory implies that a decline in the volatility of a country's inflation rate should lead, other things equal, to a decline in the volatility of its bond yields. Similarly, a fall in the volatility of the inflation differential between countries should lead to a fall in the volatility of their bilateral exchange rates. In this paper, we use data on inflation, bond yields and exchange rates for many OECD countries over the past two decades to test these theoretical predictions.

We find some empirical evidence that cross-country differences in inflation volatility help to explain cross-country differences in the volatility of bond yields. This evidence is most compelling when countries with very volatile inflation rates are included in the sample. We also find evidence that the widespread fall in inflation volatility in the late 1980s and 1990s has been responsible for a fall in bond yield volatility, although the fall in the volatility of bond yields has been less marked than the fall in inflation volatility.

By contrast, for OECD countries with moderate inflation rates, there is little evidence that the volatility of inflation differentials helps to explain exchange rate volatility. The large fall in the volatility of the inflation differentials between many pairs of countries in the 1990s has been associated with little, if any, systematic fall in the volatility of their bilateral exchange rates.

The rest of the paper is divided into two sections. The next section marshals the empirical evidence about inflation volatility and bond yield volatility on the one hand, and inflation differential volatility and exchange rate volatility on the other. The final section broadens the focus of the paper to consider the wider economic debate about financial market volatility, and discusses why we find different results in the bond and foreign exchange markets.