Monetary policy and asset price volatility

NBERWORKINGPAPERSERIESMONETARYPOLICYANDASSETPRICEVOLATILITYBenBernankeMarkGertlerWorkingPaper7559“NewChallengesforMonetaryPolicy”,JacksonHole,Wyoming,August26-28,1999.TheauthorsacknowledgeresearchsupportfromtheNationalScienceFoundation.RefetGurkaynak,MatthewMoore,PauRabenal,andFedericoRavennaprovidedexcellentresearchassistance.WethankRudigerDornbuschforusefulcomments.TheviewsexpressedhereinarethoseoftheauthorsandarenotnecessarilythoseoftheNationalBureauofEconomicResearch.©2000byBenBernankeandMarkGertler.Allrightsreserved.Shortsectionsoftext,nottoexceedtwoparagraphs,maybequotedwithoutexplicitpermissionprovidedthatfullcredit,including©notice,isgiventothesource.MonetaryPolicyandAssetPriceVolatilityBenBernankeandMarkGertlerNBERWorkingPaperNo.7559February2000JELNo.E5,E44ABSTRACTWeexploretheimplicationsofassetpricevolatilityforthemanagementofmonetarypolicy.Weshowthatitisdesirableforcentralbankstofocusonunderlyinginflationarypressures.Assetpricesbecomerelevantonlytotheextenttheymaysignalpotentialinflationaryordeflationaryforces.Rulesthatdirectlytargetassetpricesappeartohaveundesirablesideeffects.Webaseourconclusionson(i)simulationofdifferentpolicyrulesinasmallscalemacromodeland(ii)acomparativeanalysisofrecentU.S.andJapanesemonetarypolicy.BenBernankeMarkGertlerWoodrowWilsonSchoolofPublicandDepartmentofEconomicsInternationalAffairsNewYorkUniversityPrincetonUniversity269MercerStreet,7thFloorPrinceton,NJ08544NewYork,[e-mail]@fasecon.econ.nyu.edu2PresentedattheFederalReserveBankofKansasCityconferenceon“NewChallengesforMonetaryPolicy”,JacksonHole,Wyoming,August26-28,1999.TheauthorsacknowledgeresearchsupportfromtheNationalScienceFoundation.RefetGurkaynak,MatthewMoore,PauRabanal,andFedericoRavennaprovidedexcellentresearchassistance.WethankRudigerDornbuschforusefulcomments.IntroductionOverthepasttwentyyearstheworld’smajorcentralbankshavebeenlargelysuccessfulatbringinginflationundercontrol.Whileitisprematuretosuggestthatinflationisnolongeranissueofgreatconcern,itisquiteconceivablethatthenextbattlesfacingcentralbankerswilllieonadifferentfront.Onedevelopmentthathasalreadyconcentratedthemindsofpolicy-makersisanapparentincreaseinfinancialinstability,ofwhichoneimportantdimensionisincreasedvolatilityofassetprices.Borio,Kennedy,andProwse(1994),amongothers,documenttheemergenceofmajorboom-bustcyclesinthepricesofequityandrealestateinanumberofindustrializedcountriesduringthe1980s.NotableexamplesincludetheUnitedStates,Japan,theUnitedKingdom,theNetherlands,Sweden,andFinland.Associatedwiththe“bust”partoftheassetpricecycleinmanyofthesecasesweresignificantcontractionsinrealeconomicactivity.Forexample,manyeconomistsattributeatleastsomepartofthe1990recession(andtheslowrecovery)intheUnitedStatestotheprecedingdeclineincommercialrealestateprices,whichweakenedthecapitalpositionsofbanksandthebalancesheetsofcorporateborrowers(BernankeandLown,1991).Morerecently,ofcourse,wehaveseenassetpricecrashesinEastAsiaandLatinAmerica,alongwithcontinuedstagnationofstockandlandpricesinJapan,allofwhichhavebeenassociatedwithpooreconomicperformance.Withtheseexperiencesin3mind,someobservershaveviewedtheremarkableriseofthepastfewyearsinU.S.stockprices,andtoalesserextentinrealestateprices,asanominousdevelopment.Ofcourse,asofthiswriting,whethertheU.S.stockmarketboomwillbesustainedorwillendintearsisanybody’sguess.Inthispaperweaddressthequestionofhowcentralbankersoughttorespondtoassetpricevolatility,inthecontextofanoverallstrategyformonetarypolicy.Tobeclear,weagreethatmonetarypolicyisnotbyitselfasufficienttooltocontainthepotentiallydamagingeffectsofboomsandbustsinassetprices.Well-designedandtransparentlegalandaccountingsystems,asoundregulatorystructurethathelpstolimittheriskexposureofbanksandcorporations,andprudentfiscalpoliciesthathelpinstillpublicconfidenceineconomicfundamentals,areallvitalcomponentsofanoverallstrategytoinsulatetheeconomyfromfinancialdisturbances.However,ourreadingofhistoryisthatassetpricecrasheshavedonesustaineddamagetotheeconomyonlyincaseswhenmonetarypolicyremainedunresponsiveoractivelyreinforceddeflationarypressures.Thisobservationisourjustificationforfocusingonmonetarypolicyhere.Theprincipalargumentofthepaperiseasilystated.Ourviewisthat,inthecontextofshort-termmonetarypolicymanagement,centralbanksshouldviewpricestabilityandfinancialstabilityashighlycomplementaryandmutuallyconsistentobjectives,tobepursuedwithinaunifiedpolicyframework.Inparticular,webelievethatthebestpolicyframeworkforattainingbothobjectivesisaregimeofflexibleinflationtargeting,eitheroftheimplicitformnowpracticedintheUnitedStatesorofthemoreexplicitandtransparenttypethathasbeen4adoptedinmanyothercountries.(Wepreferthelatter,forreasonsexplainedbrieflyattheconclusionofthepaper.)Theinflation-targetingapproachdictatesthatcentralbanksshouldadjustmonetarypolicyactivelyandpreempti