>Monetary Policy and the Myth of ‘Bubbles’ in Asset Prices

Monetary policy and asset prices: The consensus view
The theory and practice of monetary policy in the world’s developed economies since the early 1990s has converged around a set of broad principles. Price stability has become the main focus of monetary policy, with most central banks adopting more or less formal inflation targets specifying a goal for some measure of consumer price inflation over time.2 While some central banks such as the Fed and the RBA have notionally retained other statutory policy objectives, these objectives have in practice been subordinated to the pursuit of price stability.

To facilitate this focus on price stability, central banks have been made increasingly independent of government, while also being subject to stricter accountability and transparency regimes. Monetary policy has also been separated from other traditional central bank functions, such as financial sector supervision, to ensure a singular focus on price stability. The choice of the inflation rate as the target for monetary policy reflects the unsatisfactory historical experience with the pursuit of multiple policy objectives by central banks. This was often associated with poor economic performance, including high and variable rates of inflation, as well as a lack of transparency and accountability in the conduct of monetary policy.

Central banks have also come to use an official interest rate as their main policy instrument. This has increased the transparency of central bank operations and aligns the singular focus on price stability with a single policy instrument. Monetary policy can be assessed in terms of how the official interest rate responds to macroeconomic variables. If monetary policy responds to these variables in a systematic way, it becomes possible to identify a policy rule, for example, the Taylor rule,3 which can then be used to benchmark the stance of monetary
policy. The empirical literature on monetary policy rules suggests that the behaviour of official interest rates has become more predictable in recent decades and dominated by central banks’ response to inflation.4 Official interest rates also respond to the level of economic activity because economic activity helps forecast future inflation. Attempts at including other variables such as asset prices in these policy rules have produced mixed results. This does not mean that monetary policy ignores other variables, but the response to these variables is effectively captured by the response to consumer price inflation and economic activity. Since asset prices are poor predictors of future consumer price inflation, monetary policy does not typically respond to asset prices in a systematic way.

An important implication of these developments in the theory and practice of monetary
policy is that it has become increasingly endogenous to economic activity: in other words, it is the economy that drives monetary policy, not the other way around. The literature on policy rules confirms that the conduct of monetary policy in recent decades has become less discretionary and therefore more predictable. With inflation expectations well anchored by an inflation target, the need for activist monetary policy is greatly reduced. Deviations in the official interest rate from the Taylor rule are usually small. Large deviations can help identify episodes of greater monetary policy discretion when policy may have been too easy or too tight relative to prevailing economic conditions.

Consensus under challenge: The evolving debate on the role of asset prices in monetary policy

In December 1996, Greenspan famously asked ‘how do we know when irrational exuberance has unduly escalated asset values…? And how do we factor that assessment into monetary policy?’

Greenspan suggested the following answer to his own question:
We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.7

Greenspan’s 1996 ‘irrational exuberance’ speech reflected the consensus view of the relationship between monetary policy and asset prices that informed the decision-making of the US Federal Open Market Committee (FOMC), the body that sets US interest rates.

To read the full report: MYTH OF BUBBLES