Asset Prices, Monetary Policy and Macroeconomics Stability: Empirical Evidence for Canada

Abstract

Although the Bank of Canada admits stock market price index are considered in its policy deliberations because of their effects on inflation or output gap, the Bank of Canada denies trying to stabilize asset prices around fundamental values. However, since the start of the Bank of Canada we have seen a boom as well as a bust in the stock market. Are we to believe that the Bank of Canada did not react to these stock market fluctuations, apart from their impact consequences on economy? We investigate this issue by using a structural model based on the New Keynesian framework that is augmented by a stock market variable. We use an econometric method that allows us to distinguish the direct effect of stock prices on Bank of Canada policy rates from indirect effects via inflation or GDP. Our results suggest that stock market stabilization plays a larger role in Bank of Canada interest rate decisions than it is willing to admit. Empirically to infer the monetary policy preferences and having a best interpretation of the parameters, we follow Favero and Rovelli's (2003) approach. The results reveal practical monetary policy lessons: (i) Canadian monetary authorities should generally respond to stock market price index as long as this variable contain reliable information about inflation and output, but it should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices. This finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. (ii) The monetary authorities' preferences have changed between different subperiods. In particular, the parameter associated with the financial indicator's target is highly significant at the last subperiod. Furthermore, these results give new insights into the influence of financial variables on monetary policy and should provide relevant understandings regarding the opportunities and limitations of incorporating financial indicators in monetary policy decision making. This indicates that while the Bank of Canada is targeting the information contained in this index in order to avoid inflationary pressures from imbalances in the asset and financial markets. (iii) The findings suggest that the introduction of inflation targeting in Canada was accompanied by a fundamental change in the objectives of monetary policy, not only with respect to the average target, but also in terms of precautions taken to keep inflation in check in the face of uncertainty about the economy. The economic conditions related to the aggregate demand have been favorable in comparison with those related to the aggregate supply and the stock market price fluctuations. The main contribution of this paper is to successfully not only prove that the Bank of Canada does care about output and stock market price stabilization (in addition to inflation stabilization) but reveal that targeting financial conditions might be the solution to avoid imbalances in the financial and asset markets and, consequently, to av...