The widespread liberalization of financial markets in recent years has increased the interest of central banks in asset price movements. Two key questions arise: should asset prices be an objective of m

onetary policy? And how can asset prices be used as indicators in the formulation of monetary policy?

The appropriate role of asset prices in monetary policy is a matter of considerable debate among central bankers. Asset prices provide timely and forward-looking information. Moreover, the involvement of a central bank in setting interest rates, supervising banks and last resort lending puts it in a unique position to facilitate the functioning of asset markets. Developments in broader asset markets may have implications for banking and payments stability - and indeed for macroeconomic stability.

A new Report from CEPR and the Bank for International Settlements brings together the views of four leading economists on the proper role of monetary policy vis-à-vis asset markets. First, they ask, should monetary policy focus solely on price stability - or should it also aim at asset price stability in order to reduce the risk of financial crisis? And second, do asset prices provide reliable information about future economic conditions, such as inflation and real growth, which can be used in policy formulation.

The almost unanimous view on the first question is that making asset price stability one of the objectives of monetary policy would be ill-advised. Just as the process whereby the equilibrium value of asset prices is determined remains only vaguely understood, so too is the link between monetary policy instruments and asset prices. Nevertheless, as Mark Gertler of New York University argues, severe asset price contractions in weak underlying economic environments can be harmful. In such situations, easing policy may be appropriate.

But if asset price contractions can have harmful effects, should central banks undertake pre-emptive strikes if they perceive ‘over-valuation’? Gertler answers no. First, it is not clear why central bankers should have more information about asset fundamentals than private market participants: while a sharp stock price increase might reflect a bubble, it might equally reflect fundamentals. Second, the underlying economic environment is critical: rather than focusing attention on the absolute level of share prices, about which it can say little with certainty, a central bank should pay attention to the underlying risk exposure of private financial institutions and non-financial borrowers.

The CEPR publication reveals a wider spectrum of opinions on the information content of asset prices. Some researchers feel that asset prices can help to measure a central bank’s credibility and the stance of monetary policy. Others express distinct scepticism about the predictive power of asset prices, stressing the dangers of circularity if central banks use the information contained in asset prices to set the policy stance.

Luigi Spaventa of CONSOB and CEPR, for example, considers the case of a central bank setting its monetary policy on the basis of the information on future interest rates implied in the term structure expressed by the market at a given moment. In his view, this poses a delicate problem: what does the market know that the central bank does not know? Can it be presumed that the market possesses an informational advantage over the central bank, and, if so, why?

As it is implausible to think that the central bank does not have access to, or is unable to process, all the information available to the market (if anything, the opposite is likely to be true, considering the relative weights of time and resources devoted to forecasting), Spaventa concludes that what the market expresses is its outlook and assessment of the current and future behaviour of the central bank itself. So if a central bank is pursuing a policy whereby inflation should not exceed 2% and the prediction extracted from the term structure is a rate of 3%, it is unlikely that this information will be based on something unknown to the authorities: what is at stake is probably the central bank’s credibility and commitment to its preannounced policies.

This is not to say that this information is of no use: on the contrary, it may provide a useful yardstick by which the central bank can measure its credibility and, if necessary, an incentive to make its commitment more credible. But it also follows that the forecasts extracted from yield curves should be treated with caution: they may reflect the central bank’s reputation, and, insofar as they are affected by the policies they are supposed to guide, they may pose a problem of circularity.

The contribution of Marvin Goodfriend of the Federal Reserve Bank of Richmond explores the topical issue of deflation. He notes that in an inflationary environment, where money steadily loses its purchasing power, the public holds as little money as is convenient for transactions purposes, and the store of value property of money is of secondary importance for monetary policy. In contrast, money can become a relatively desirable asset in a deflationary world in which its purchasing power is expected to rise steadily.

Goodfriend argues that now that the possibility of deflation is in the public’s mind, central banks should begin to take steps to reduce the likelihood of deflation scares. Such scares are potentially dangerous because they can lead the public to behave in a way that actually creates deflation. If the public begins to believe that the purchasing power of money will rise significantly over time, then it has an incentive to hoard cash,

especially if nominal short-term interest rates are near zero. By hoarding cash and deferring spending, the public creates a deficiency of aggregate demand and unemployment - the very conditions that can bring on deflation.

Protracted inflation is a monetary phenomenon that can be controlled by a determined central bank. Similarly, a central bank has the power to guard against deflation by pursuing sufficiently expansionary monetary policy. While this can be done in principle, operational issues need to be thought through beforehand. For example, resisting deflation may involve pushing short-term nominal interest rates down to zero, and then expanding the money supply still further by acquiring a variety of longer-term assets. Just what assets should be purchased and how this should be done needs to be planned in advance.

A central bank fights deflation by saturating the economy with cash so that people use excess money balances to purchase assets such as consumer and producer durables and perhaps foreign exchange. The portfolio reallocation process drives up durable goods prices, depreciates the exchange rate, revives aggregate demand, and thereby acts to reverse the deflation.

To begin the fight against deflation, Goodfriend suggests that central banks might consider explaining the mechanics of deflation fighting to the public. It would also be helpful to announce a lower bound on a tolerance range for inflation. They might even announce their contingency plans for fighting deflation in order to increase further their anti-deflation credibility. While paying more attention to the possibility of deflation now runs the risk of heightening the public’s concern, not addressing the problem at an early date runs the greater risk of slipping inadvertently into deflation in the future.