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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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