RDP 9709: Asset-price Bubbles and Monetary Policy 2. Asset Prices and Monetary Policy

In an inflation-targeting regime, how should monetary policy respond to movements in asset prices? There is no clear consensus as to the appropriate answer. Some argue that the price index targeted by the central bank should include the prices of assets as well as the prices of goods and services. Others argue that asset prices are relevant to monetary policy only in so far as they affect forecasts of future goods and services price inflation. Finally, others see changes in asset prices as having implications for the stability of the financial sector, and thus perhaps indirectly for monetary policy.

2.1 The Inclusion of Asset Prices in an Overall Price Index

Goodhart (1993) has argued that, in principle, the central bank should target a price index that not only includes the prices of goods and services, but also the prices of future goods and services. Since these prices cannot be measured directly, Goodhart claims that a reasonable alternative is to include the prices of a broad range of assets in the price index targeted by the central bank. He suggests that this is appropriate since asset prices capture the value of claims on a basket of future goods and services. The argument rests on earlier work by Alchian and Klein (1973) who argued that a general measure of inflation should capture changes in the money cost of a constant utility basket of current and future goods and services.

In addition to the formidable practical problem associated with obtaining accurate and broadly based indices of asset prices, Goodhart's proposal has two conceptual difficulties.

The first is a result of the way inflation targets are actually implemented. Central banks with inflation targets do not target the current rate of inflation but rather the future expected rate of inflation, or more precisely, the future expected path of inflation. Goodhart's and Alchian and Klein's concern was that by focusing on the current rate of inflation, central banks would ignore future inflationary pressures which were reflected in current asset prices, but not current goods prices. By including asset prices in the targeted index, this might be overcome. In practice, however, the fact that inflation targets are forward looking means that central banks are already directly concerned with future inflationary pressures.

The second difficulty is that asset prices change for a variety of reasons that are not associated with future inflationary pressures. In some cases, rising asset prices might mean reduced inflationary pressures, while in other cases the reverse might be true. Understanding the source of asset price movements and the implications for future inflation is important in determining the appropriate monetary policy response (Smets 1997). If asset prices are included in the targeted price index, then the ability of monetary policy to respond differently according to the nature of asset price change is severely restricted.

In Australia's case, the most obvious example of this point is the exchange rate. As the terms of trade rise, the exchange rate tends to appreciate (Gruen and Dwyer 1995; Smets 1997; and Tarditi 1996). This appreciation helps reduce any inflationary impact that would otherwise be associated with the increase in the terms of trade; thus the case for an easing of monetary policy in response to an appreciation of the currency is less than clear. In contrast, if the exchange rate appreciation is not based on underlying fundamentals, there is a stronger case for a change in monetary policy, especially if the appreciation is likely to reduce expected inflation.

Another example is the stock market. If a rise in equity prices has little fundamental justification, expected inflation is likely to rise, particularly if aggregate demand responds to the perceptions of higher wealth. In this case there is an argument for tighter monetary policy. In contrast, suppose the rise in equity prices reflects an improved outlook for corporate profits as a result of faster underlying productivity growth. In this case, the central bank's forecast of future inflation might actually fall. Tightening monetary policy in response to this change in asset prices would clearly be inappropriate.

To summarise, including asset prices in an index of prices which the central bank targets is not necessary in order for the central bank to focus on future inflation. Nor is this sensible since the appropriate monetary policy response to a change in asset prices will depend on the source of that change. We address each of these points in our model presented in Section 3. Firstly, we make it explicit that the central bank's objective is to target expected future inflation. Secondly, we restrict ourselves to a discussion of the behaviour of asset prices away from some fundamental level – that is, we look at asset-price bubbles.

2.2 The Effect of Asset Prices on Future Inflation

Some authors argue that in certain cases, central banks should respond to changes in asset prices, but in a more flexible fashion than would be the case if asset prices were included in the targeted price index. The guideline they propose is for the central bank to calculate the effect of the change in asset prices on expected inflation and then adjust the interest rate to bring expected inflation back to target.

An increase in asset prices can increase expected future goods and services price inflation. This can occur through a number of channels. The most frequently discussed is the wealth effect of higher asset prices; by increasing perceptions of wealth, higher asset prices can lead to increased consumption. Consumption might also be stimulated through an improvement in consumer sentiment resulting from higher asset prices. If the resulting increase in aggregate demand outstrips the increase in supply, inflation pressures are likely to rise. This process can be compounded if rapidly increasing asset prices generate higher expected goods and services price inflation on the part of the private sector, which then feeds through into higher actual inflation. Finally, in certain cases an increase in asset prices can signal to the central bank that the private sector is expecting higher general inflation. In turn, this information might affect the central bank's expectation of future inflation.

We include the standard effect of asset price changes on inflation in our model in Section 3. This can be interpreted as capturing these direct wealth effects and/or the signalling relationship that links higher asset prices to expected increases in future aggregate demand and hence, future inflationary pressures.

2.3 Asset Prices and Financial Stability

While increases in asset prices tend to have small direct effects on goods and services prices, they can have much larger indirect effects through their impact on the financial system. If increases in asset prices are not based on fundamentals, a correction in prices is inevitable. When the correction occurs it can be very costly if during the period of increasing prices, financial institutions have extended credit for the purchase of assets, or accepted assets as collateral for loans. In such cases, falling asset prices can lead to large losses amongst financial institutions and can impair the stability of the financial system. This may result in a protracted period of growth below potential, and low, or even negative, goods and services price inflation.

The connection between asset prices and the stability of the financial system introduces an important asymmetry into the effect of asset prices on inflation. The discussion above suggested that while rising asset prices might contribute to higher goods and services price inflation, the effect is in general, relatively small. In contrast, the unwinding of asset-price bubbles can cause problems for the financial system, and have a significant deflationary effect.

In Australia, the collateral for most loans is real estate; this means that changes in the price of real estate not only have potential effects on aggregate demand, but can also affect the health of the financial system. If nominal property prices fall, and financial institutions have made loans with relatively high loan-to-valuation ratios, the underlying collateral may be insufficient to match the face value of the loan. This can impose substantial losses on the financial system and have adverse effects on the future availability and cost of intermediated finance.

In a similar vein, changes in property prices can affect the balance sheets of corporations. A fall in property prices reduces the net value of firms and, due to imperfections in credit markets, makes it more difficult to attract intermediated finance for a given investment project (Bernanke and Gertler 1990; Gertler 1992; Kiyotaki and Moore 1995; and Lowe and Rohling 1993). As a result, a financial accelerator acts to amplify any downturn in economic activity (Fisher 1933).

In Australia, relatively little lending by financial intermediaries has been secured against equities. Hence, booms and busts in equity prices need not have the same direct implications for the balance sheets of financial institutions that changes in property prices have had. Nevertheless, movements in equity prices can still affect the stability of the financial system. As the experience of the United States in 1987 shows, a major fall in equity prices can create problems in the payments system, with potentially large adverse consequences. Further, if a share market crash leads to a severe contraction in aggregate demand, borrowers may find themselves unable to repay their loans. As share ownership becomes more widespread, the aggregate demand effects of changes in equity prices may become more pronounced.^[1] Continued financial innovation may also see the growth of lending secured against equities, adding to the exposure of financial institutions to changes in equity prices. Such a change in the pattern of financial intermediation would increase the relevance of stock prices for monetary policy.

In the model presented below we include the indirect, and asymmetric effect of falling asset prices on goods and services price inflation. This indirect effect captures the (circular) links between falling collateral values, financial instability, contractions in intermediated finance and falling aggregate demand. For the moment we focus on the role of monetary policy and ignore the influence of prudential policy. However, we later discuss the important issue of prudential supervision and describe how it can be incorporated into our basic model.

Footnote

The 1997 Australian Sharemarket Survey finds that 34 per cent of the Australian adult population have direct or indirect share holdings. This percentage would be considerably higher if account was taken of employer-funded pension schemes. [1]