RDP 2003-11: How Should Monetary Policy Respond to Asset-Price Bubbles? 1. Introduction

Asset-price bubbles pose difficult problems for monetary policy, and despite considerable debate no consensus has yet emerged on the appropriate strategy for monetary policy-makers in the presence of such bubbles.

Different views about the appropriate role of monetary policy in the presence of asset-price bubbles do not arise primarily because of differences about the objectives of monetary policy. These objectives, it is usually agreed, are to maintain low inflation and to limit the volatility of inflation and output, thereby contributing to stability in both the macroeconomy and the financial system. Rather, the different views are about how best to achieve these objectives.

One view is that monetary policy should do no more than follow the standard precepts of inflation targeting. Proponents of this view would acknowledge that rising asset prices often have expansionary effects on the economy, and might sometimes also provide a signal for incipient inflationary pressures, so that some tightening of monetary policy might be appropriate. According to this view, however, policy should only respond to observed changes in asset prices to the extent that they signal current or future changes to inflation or the output gap. There should be no attempt to use policy either to gently lean against a suspected asset-price bubble while it is growing or, more aggressively, to try to burst it. This view of the appropriate monetary policy response to asset-price bubbles has been put recently by Bernanke (2002).

An alternative view is that monetary policy should aim to do more than respond to actual and expected developments in inflation and the output gap. Cecchetti, Genberg and Wadhwani (2003), prominent proponents of this alternative view, put the argument in these terms:

… central banks seeking to smooth output and inflation fluctuations can improve … macroeconomic outcomes by setting interest rates with an eye toward asset prices in general, and misalignments in particular … Raising interest rates modestly as asset prices rise above what are estimated to be warranted levels, and lowering interest rates modestly when asset prices fall below warranted levels, will tend to offset the impact on output and inflation of [asset-price] bubbles, thereby enhancing overall macroeconomic stability. In addition, if it were known that monetary policy would act to ‘lean against the wind’ in this way, it might reduce the probability of bubbles arising at all, which would also be a contribution to greater macroeconomic stability. (p 429, italics added)^[1]

We argue here that it is not clear that central banks should follow this advice. There is no universally optimal response to bubbles, and the case for responding to a particular asset-price bubble depends on the specific characteristics of the bubble process.

We present a simple model of the macroeconomy that includes a role for an asset-price bubble, and derive optimal monetary policy settings for two policy-makers. The first policy-maker, a sceptic, makes no attempt to forecast future movements in asset prices when setting policy, perhaps because she does not believe in the existence of the bubble or, alternatively, does not believe that monetary policy should actively respond to it. Her policy settings define the standard inflation-targeting benchmark in our model. The second policy-maker, an activist, takes into account the complete stochastic implications of the bubble when setting policy.

Once the bubble has formed, it is assumed to either grow each year with some probability, or to collapse and disappear. Crucially, and realistically, monetary policy in the model affects the economy with a lag, so that policy set today has its initial impact on the economy next year, by which time the bubble will have either grown further or collapsed.

For an activist policy-maker, it follows that there are two countervailing influences on monetary policy in the presence of the bubble. On the one hand, policy should be tighter than the standard inflation-targeting benchmark to counter the expansionary effects of future expected growth in the bubble and, in some formulations, to raise the probability that the bubble will burst. On the other hand, policy should be looser to prepare the economy for the possibility that the bubble may have burst by the time policy is having its impact on the economy.

Which of these two influences dominates? For intermediate and larger bubbles – which are of most importance to policy-makers – we argue that it depends on the characteristics of the bubble process. There are circumstances in which the activist should recommend tighter policy than the sceptic. This is likely to be the appropriate activist advice when one or more of the following conditions applies: the probability that the bubble will burst of its own accord over the next year is assessed to be small; the bubble's probability of bursting is quite interest sensitive; efficiency losses associated with the bubble rise strongly with the bubble's size; or, the bubble's demise is expected to occur gradually over an extended period, rather than in a sudden bust.

Alternatively, however, when these conditions do not apply, it is more likely that the activist should recommend looser policy than the sceptic. This result makes clear that there is no single optimal rule for responding to all bubbles, and also illustrates the quite high level of knowledge of the future stochastic properties of the bubble that is required to set appropriate activist policy.

Footnote

Cecchetti et al are careful to argue that monetary policy should not target asset prices. To quote them again, ‘we are not advocating that asset prices should be targets for monetary policy, neither in the conventional sense that they belong in the objective function of the central bank, nor in the sense that they should be included in the inflation measure targeted by monetary authorities’ (2003, p 429, italics in the original). [1]