Monetary Policy and Asset Prices

MonetaryPolicyandAssetPricesByAndrewJ.FilardoDespitethelowinflationofrecentyears,someobservershavewonderedwhetherrapidgainsinU.S.assetpricesfore-shadowrisinginflationarypressures.WouldU.S.monetarypolicybeimprovedifFederalReservepolicymakersreactedsystematicallytochangesinthepricesofwidelyheldassetssuchasstocksandhouses?Somemonetaryexpertsbelieveso.Inparticular,CharlesGoodhart,aformermemberoftheBankofEngland’sMon-etaryPolicyCommittee,arguesthatcentralbanksshouldconsiderusinghousingprices,andperhaps,buttoamuchlesserextent,stockmarketpricestoguidetheirpolicydecisions.Goodharthasrecommendedthatcentralbanksreplaceconventionalinflationmeasures—suchastheCPIorPCEpriceindex—withabroadermeasurethatincludeshousingandstockmarketprices(weightedappropriately).Thismeasurehasthepotentialtoimprovemacroeconomicperformanceifassetpricesreliablypredictfutureconsumerpriceinflation.Otherexperts,however,questiontheabilityofhousingandstockpricestopredictfutureinflation.And,evenifassetpriceshelppredictinflation,acentralbank’sreactionstosuchvolatileassetpricesmightnotnecessarilyimprovemacro-economicperformance.ThisarticleevaluatesthenetbenefitstotheU.S.economyofadoptingGoodhart’srecom-mendation.Thefirstsectionreviewsthehis-toricalandtheoreticalmotivationunderlyingtherecommendationanddiscussesitsmone-tarypolicyimplications.ThesecondsectionexaminesempiricallywhetherU.S.housingandstockmarketpriceshelppredictfutureconsumerpriceinflation.Basedonthesefind-ings,thethirdsectionsimulatesamacroeco-nomicmodeltoexplorethenetbenefitsofapolicythatrespondstotheseassetprices.ThearticleconcludesthatadoptingGoodhart’srecommendationwouldnotimproveU.S.eco-nomicperformance.I.BACKGROUNDONGOODHART’SRECOMMENDATIONPolicymakershaverenewedtheirinterestintherelationshipbetweenassetpricesandcon-sumerpriceinflationinthelastdecade.Thisinteresthasbeensparkedinpartbythebehaviorofinternationalassetprices—especiallyhous-ingandstockmarketprices—andinflationinJapanandtheUKduringthelate1980sandearly1990s.1Goodhart’srecommendationhasAndrewJ.FilardoisanassistantvicepresidentandeconomistattheFederalReserveBankofKansasCity.Theauthorbene-fitedfromconversationswithCharlesGoodhart.HankHui,aresearchassociateatthebank,helpedpreparethearticle.Thisarticleisonthebank’swebsiteat’srecommendationanddis-cussesitsmonetarypolicyimplications.InternationalexperiencesEconomicdevelopmentsinJapanandtheUKduringthelate1980sandearly1990smayprovideimportantlessonsfortheUnitedStates.BothJapanandtheUKwereenjoyinglow,sta-bleinflationratesinthefaceofrapidassetpriceappreciation.2Bothnationseventuallysawcon-sumerpriceinflationrisesignificantly,however,followedinturnbyatighteningofmonetarypolicy,decliningassetprices,andultimatelyrecession.Japaneseexperience.Inthelate1980s,Japan’seconomywasloggingastellarperformance.Economicgrowthwassolid,labormarketsweretight,andinvestmentspendingwasstrong.Twofactorsthathelpedsustainthisgrowthwereeasycreditconditionsandlowinterestrates.But,accompanyingthissuperioreconomicper-formancewithessentiallyzeroinflationwasatriplingofbothhousingandstockpricesfrom1985to1990(Chart1).Thefavorableinflationperformancewashelpedinpartbystronginvest-mentspendingthathelddownunitlaborcosts.ItisnotanexaggerationtosaythatJapaneseeconomicconditionsappearedsosoundinthe1980sthatJapandevelopedareputationforeconomicinvulnerability.Theeconomicperformancebegantosourin1989.Inflationroseandmonetarypolicybecametighter.Stockpricesstartedtheirlongretreat,followedbyhousingprices.By1991,inflationpeakedatnearly4percent.Sincethen,effortstolowerinflationhavebeenasso-ciatedwithaperiodoflowerassetpricesandeconomicmalaise.UKexperience.TheUKexperienceparallelstheJapaneseexperienceinseveralimportantways.Inthelate1980s,theUKeconomywasexpandingwithstrongconsumptiongrowthandhighcapacityutilization.From1985to1987,thevalueofthestockmarketdoubled,whilehousingpricesnearlydoubled(Chart2).In1988alonehousingpriceinflationreachedanannualrateofroughly35percent.Despitethisrapidriseinassetpriceinflation,UKcon-sumerpriceinflationaveragedjust4percent.Followingtheaccelerationinassetprices,though,inflationstartedtoclimbinearly1988,risingto6percentbytheendof1989andnearly9percentin1990.Goodhart(1995)singledouthousingmar-ketdevelopmentsduringtheperiodasearlywarningsignsofunderlyinginflationarypres-sures.Bankcreditexpansionwasparticularlyrapid,inpartbecauseofthefinancialliberal-izationofmortgagelendinginstitutionsinthe1980s.3Theeasiercreditconditionsfueledhousingprices,andultimatelythesepressuresfoundtheirwayintogoodsmarketprices.Higherinterestratesandslowermoneygrowtheventuallyslowedinflation,butatthecostofarecession.Déjàvu?Insomerespects,recentU.S.experi-enceparallelstheexperiencesinJapanandtheUK.Inparticular,U.S.housingandstockmar-ketpriceshavesoaredoverthelastfive