Asset Prices in a Flexible Inflation Targeting Framework

Abstract

We argue that there are sound theoretical reasons for believing that an inflation targeting central bank might improve macroeconomic performance by reacting to asset price misalignments over and above the deviation of, say, a two-year ahead inflation forecast from target. In this paper, we first summarize the arguments for our basic proposition. We then discuss some of the counter-arguments. Specifically, we counter those who argue that reacting to asset prices does not improve macroeconomic performance by claiming that they are attacking the 'straw man' under which central bankers react in the same way to all asset price changes. We continue to emphasize that policy reactions to asset price misalignments must be qualitatively different from reactions to asset prices changes driven by fundamentals. Hence, we stand by our earlier results and conclusions. In practice, we do believe that central bankers can detect large misalignments (e.g. the Nikkei in 1989 or the NASDAQ in early 2000), and that they might be in a better position to react to long-lived bubbles than many market participants. However, we recognize that our proposal may present communication challenges, and it is critically important that policy set to react to asset price misalignments both be explained well and that it be based on a broad consensus. It is also important to emphasize that our proposal is wholly consistent with the remit of most inflation-targeting central banks, as we are recommending that while they might react to asset price misalignments, they must not target them.

Banking Competition, Collateral Constraints and Optimal Monetary Policy

“…9 These features will help us understand the stabilization goals and trade-o¤s of monetary policy. We turn to this now.…”

The Role of State Intervention in the Financial Sector: Crisis Prevention, Containment and Resolution

“…Because asset prices may rise for many reasons, including changes in fundamentals, this view holds that monetary policy should react to deviations of asset prices from their underlying fundamentals rather than deviations from any particular target level. Formally, while the monetary authorities' objective functions should continue to be defined only in terms of goods inflation, their reaction function should include not only inflation forecasts and the output gap, but also measures of asset price misalignment-what has been labeled "flexible inflation targeting" (Cecchetti, Genberg, and Wadwhani 2003).…”

Monetary policy and real estate prices: a disaggregated analysis for Switzerland

“…Smets [1997] shows that in a comparatively simple macroeconomic framework, asset prices turn out to be part of an optimal monetary policy reaction function whenever aggregate demand depends positively on real asset prices. Cecchetti et al [2000] and Cecchetti, Genberg and Wadhwani [2002] argue that reacting to asset price movements might be advantageous due to the fact that asset prices have implications for price stability at a different horizon from that of a typical inflation forecast. Bordo and Jeanne [2002] study monetary policy in a New…”