European Economic Perspectives 26

Moving Targets

Should central banks respond to movements in equity, housing and foreign exchange markets? A new Report, published jointly with the International Centre for Monetary and Banking Studies in Geneva, argues that they should.

Developments in asset markets can have a significant impact on both inflation and real economic activity. Large swings in equity, housing and foreign exchange markets have often coincided with prolonged booms and busts. So it is worth asking whether there are any actions central banks can, and should, take to minimize the likelihood of macroeconomic instability arising from extreme changes in asset prices. Or – as many influential economists argue – should monetary policy-makers ignore asset prices and set interest rates in response only to inflation forecasts and perhaps the output gap?

In a new Report, four leading economists argue that a central bank concerned with stabilizing inflation is likely to achieve superior performance by adjusting its policy instruments in response not only to forecasts of inflation and the output gap but also to asset prices. This conclusion is based in part on the view that reaction to asset prices in the normal course of policy-making will reduce the likelihood of asset price misalignments in the first place. Furthermore, inflation forecasts depend on assumptions about asset prices, which must, in turn, depend on views about the size of asset price misalignments.

A central bank that reacts to asset price changes must attempt to estimate misalignments, something that many regard as impractical. The Report takes issue with this argument: the difficulties associated with measuring asset price misalignments are not substantially different from those of estimating such theoretical constructs as potential GDP or the equilibrium real interest rate. Quite rightly, these difficulties have not prevented central banks from using the concepts in the course of monetary policy-making. Similarly, although asset price misalignments are difficult to measure, this should be no reason to ignore them.

That being said, there will always be imprecision in estimates of these misalignments, just as there are in estimates of the other key macroeconomic variables that are crucial in setting interest rates. So it is important for central bankers to develop a framework for policy-making that accounts for the various sources of uncertainty that they face in seeking to meet their inflation and growth objectives.

Should asset prices be included directly in measures of inflation? Some economists have argued that a properly constructed inflation index should be based on both the prices of what is currently consumed, which conventional consumer price indices now measure, and the prices of future goods and services (as captured by asset prices). Proponents of this view suggest that monetary policy should seek to stabilize such a combined index.

There are reasons to be sceptical of the arguments for such an index since no one has yet shown why focusing on such a measure of prices is the most effective way to reduce inflation. Furthermore, most common implementations of this proposal place a very high weight on asset prices, which amounts to suggesting that central banks target them rather than the prices of current consumption. The Report provides an alternative set of calculations based on the idea that inflation affects all nominal prices, including those of equity and housing. The conclusion is that changes in equity prices are much too ‘noisy’ to be useful in inflation measurement, but that house prices contain significant useful information about aggregate price movements.

The Report also asks whether asset prices can be used to improve forecasts of future inflation. Many studies show a relationship between retail price inflation and movements in equity prices, housing prices and exchange rates. The Report’s calculations as well as assessment of other evidence suggest that asset prices have a strong effect on future inflation, although the impact differs across countries and may shift over time.

This article summarizes ‘Asset Prices and Central Bank Policy’, the second Geneva Report on the World Economy (CEPR, 2000) by Stephen Cecchetti (Ohio State University), Hans Genberg (Graduate Institute of International Studies, Geneva), John Lipsky (Chase Manhattan Bank) and Sushil Wadhwani (Monetary Policy Committee, Bank of England).

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