Monetary Policy and Asset Price Booms: A Step Towards a Synthesis

Abstract

Should a monetary policy maker following a Taylor-type rule set a higher policy rate than the level suggested by the rule because of a possibility of an asset price bust in the near future? Our answer to this question for monetary policy makers who have two scenarios of 'boom-bust cycle' and 'stable growth' is yes if the following two conditions are satisfied. First, early warning indicators based on credit and residential investment data show a high probability of a boom-bust cycle occurring. Second, the policy rate path that minimizes the boom-bust probability-based expected value of a social loss associated with inflation and the output gap over the two scenarios is higher than the rate path by the Taylor-type rule. Our counterfactual analysis shows that the Fed should have raised the federal funds rate by a small amount over and above the level suggested by a Taylor-type rule in the early 2000s.

Money and credit during normal times and house price booms: evidence from time-frequency analysis

“…3a). In turn, money and credit-based indicators are in many empirical studies evidenced as a reliable early warning signal of a new asset price boom (for example, Fujiki et al 2016). In the short run, however, the link may be hidden because the co-movements of money and credit are then rarely statistically significant.…”

Monetary Policy, Inflation, and Rational Asset Price Bubbles

“…Dupor (2005), Detken and Smets (2004), and Smets and Wouters (2005) analyze Ramsey-optimal monetary policy in the New Keynesian model with nonfundamental shocks to asset prices or investment and show that Ramsey policy deviates from the sole pursuit of inflation stabilization. In a simpler framework that is not fully microfounded but explicitly incorporates a crisis probability, Svensson (2017) and Ajello et al (2019) find some but practically negligible role of leaning against the wind-monetary policy that is somewhat tighter during booms than what is consistent with flexible inflation targeting-while Fujiki et al (2016) and Adrian and Liang (2018) find a significant role of leaning against the wind.…”

“…(2019) find some but practically negligible role of leaning against the wind—monetary policy that is somewhat tighter during booms than what is consistent with flexible inflation targeting—while Fujiki et al. (2016) and Adrian and Liang (2018) find a significant role of leaning against the wind.…”