​Asset Prices and Monetary Policy
Ethan Ilzetzki[1]
Monday, 29 March, 2021
Summary
A majority of the CfM panel of experts on the UK economy believe that financial stability should be addressed with macroprudential tools and left out of monetary policy decisions. A larger majority opposes changing the Bank of England’s remit to target asset prices.
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Background
The April 2021 CfM survey asked the members of its UK panel of experts what role the Bank of England should play in targeting asset prices and addressing financial imbalances.
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Asset Prices and Monetary Policy: A View from New Zealand
The Government of New Zealand has instructed the country’s Reserve Bank to take housing prices into account in monetary policy decisions as of March 2021. The Reserve Bank has been a trailblazer in monetary frameworks ever since it became the first central bank to adopt inflation targeting in 1989. The government’s rationale is the surge in house prices, which increased by nearly 20% year-on-year in January 2021. Under the new remit, the Reserve Bank will retain its autonomy, but will be required to explain how its monetary policy decisions affect the housing market.
The responses to this policy announcement have been mixed. Ruchir Sharma, writing in the FT, argues that “policies need to keep up with changes in the global economy, stating that the rise in house prices in New Zealand may be unsustainable, while underscoring that house price booms lead to increased inequality. Further, He further argues that most major recessions were preceded by debt-fueled housing bubbles.
In contrast, Mike Bird, writing in the Wall Street Journal, calls on central banks to “stay away from house prices.” In his view, “monetary policy is a poor tool for fine-tuning different sectors in the economy.” He further argues that this policy will “muddle [the RBNZ’s] decision-making” and would have similar effects if adopted elsewhere.
The academic literature is also conflicted on this question. Bernanke and Gertler (2001) argue that asset prices should only affect monetary policy to the extent that they affect central banks’ inflation forecasts. Theoretically, they show that inflation targets do a sufficient job in stabilizing output even in the face of asset prices bubbles. They contend that attempts by central banks to regulate asset prices have led to mixed results. Bean (2003) concurs that the concept of inflation targeting is flexible enough to encompass forward-looking policies that learn from asset prices but asserts that asset prices shouldn’t be a target in and of themselves. Svensson (2017) develops a theoretical framework where “leaning against the wind” of financial excesses is outright harmful. He argues that such policies not only needlessly slow down the economy if a bubble doesn’t materialize but could also exacerbate a crisis if one materializes.
Alchian and Klein (1973) is a classical reference arguing for a broader measure of inflation, including asset prices, as a correct intertemporal measure of consumption. Similarly, Cecchetti et al (2000, 2002) hold that central banks should respond to asset prices and that they are able to distinguish asset price misalignments from price growth driven by fundamentals. According to Roubini (2006), central banks should attempt to “prick” asset price bubbles because of the asymmetric benefits and costs of asset price bubbles: A bursting bubble is more damaging to the economy than an inflating bubble is beneficial. Wadhwani (2008) and Cosgrove (2017) argue that incorporating asset prices into central banks’ decision rules would affect house price expectations and help avoid bubbles. Gali (2014) proposes a model of monetary policy and rational asset price bubbles. His theory suggests that central banks should balance the traditional stabilization role of monetary policy with avoidance of asset price bubbles and that the latter should take precedent when the bubble is sufficiently large. Caballero and Simsek (2020) develop a model where “prudential monetary policy” can act as a substitute for imperfect macroprudential controls. Adrian and Liang (2018) provide a useful review of the developments in this growing literature. Roger Farmer has called in several articles (2013, 2014, 2017) on central banks (including the UK Financial Policy Committee) to stabilize stock prices (a broad stock market index) so as to avoid financial crises.
Asset Prices and Monetary Policy in the UK
This month’s survey asked the panel how the Bank of England should respond to asset prices in its monetary policy decisions. The Bank’s monetary policy remit does in fact already give the Bank powers very much in line with the proposed changes in New Zealand:
Circumstances may also arise in which attempts to keep inflation at the inflation target could exacerbate the development of imbalances that the Financial Policy Committee may judge to represent a potential risk to financial stability. The Financial Policy Committee’s macroprudential tools are the first line of defence against such risks, but in these circumstances the Monetary Policy Committee may wish to allow inflation to deviate from the target temporarily, consistent with its need to have regard to the policy actions of the Financial Policy Committee.
In the first question the panel was asked whether the remit should go further and require the Bank of England to officially target asset prices with monetary policy. They were are asked for their opinion on the following proposition:
Proposition 1: The Bank of England’s mandate should be officially modified to take housing or other asset prices into account in its monetary policy decisions.
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Twenty one panel members responded to this question. A large majority (77%) of the panel thought it would be unwise to officially adapt the Bank of England’s mandate for this purpose. Several members expressed the view that the role of monetary policy is (consumer) price stabilization and output and that asset prices should therefore not play a formal role in the Bank’s policy rule. Patrick Minford (Cardiff Business School) notes that “the target of monetary policy is controlling inflation and stabilising output over the business cycle.
As the remit makes clear, the Bank’s Financial Policy Committee is the first line of defense on matters of financial stability.” He points to his own research on the topic, which indicates that these objectives are met “by the current framework, though it could be improved by targeting nominal GDP.” Kate Barker (British Coal Staff Superannuation Scheme and University Superannuation Scheme) adds that even though “housing and asset prices affect demand (and sometimes supply) and so clearly should be given appropriate weight, there is no reason to make any special reference to them.”
David Miles (Imperial College) also warns against targeting asset prices because “trying to figure out what the fundamental value of an asset should be (i.e. the price absent bubbles or irrational optimism or pessimism) is very hard.” Additional risks to a formal target include a loss of policy discretion for the MPC, mentioned by Wouter Den Haan (London School of Economics), “mission creep”, and making “the Bank's policies less easy to understand and interpret,” noted by Francesca Monti (Kings College London).
Panelists also reiterated that the Bank had both additional tools (including asset purchases and macroprudential policies) and another policy arm that could address financial excesses. As Charles Bean (London School of Economics) put it, “macro-prudential instruments are better suited to heading off a credit-driven asset-price boom as they can be targeted more precisely; monetary policy is a blunter weapon (even if it does 'get in all the cracks').”
Panel members disagreed on alternative approaches. Ricardo Reis calls for policy “stated in terms of an alternative price index to the CPI (for instance, a dynamic version that takes into account intertemporal substitution would put a larger weight on asset prices,” based on his own research (Reis, 2009). Charles Bean concurs: “I have no objection to MPC targeting an inflation measure that includes a suitable housing element, such as CPIH” In contrast, Roger Farmer (University of Warwick) writes: “I DO NOT favor the use of a single price index that includes house prices, for example, as an intermediate target for interest-rate-setting decisions. Instead, I have argued extensively in published work, that the Bank should directly stabilize the rate of growth of an asset price index by open market operations in risky versus safe assets.”
The minority supporting changing the Bank’s mandate claimed that merely taking house prices into account in monetary policy decisions is insufficient to address the challenges due to asset price changes. Jumana Saleheen (CRU Group) summarizes these arguments in three points: “1. Housing prices and housing costs affect a larger share of the population than other asset prices do. 2. There is still no good measure of inflation that includes housing costs, which is a large and important share of consumer spending. 3. While housing cycles tend to be longer than a business cycle - the two are inextricably linked.” David Cobham (Heriot Watt University) supports using macro-prudential tools as a first line of defense but supports using monetary policy as part of “an 'activist' strategy which affects expectations [and this] leads to less volatile inflation, output and asset prices than a 'sceptic' strategy which pays no attention to asset prices.” Finally, Michael McMahon (University of Oxford), while believing the Bank’s mandate should remain untouched, sees a rationale to such a policy because the “general public… see[s] house prices as part of inflation. And recent years have seen house prices rising quite strongly while CPI inflation, the central bank target, has been quite subdued.”
One possible concern of the current remit is that it muddies the waters between macroprudential and monetary policy. On this topic, the panel was are asked for their opinion on the following:
Proposition 2: Asset prices and financial imbalances are best addressed using macroprudential tools and left out of the monetary policy decision making process.
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Twenty two panellists responded to this question. A majority (51%) of the panel agreed that financial imbalances should be left to the Financial Policy Committee and remain outside the remit of monetary policy making. 39% of panel members disagreed, with half of these disagreeing strongly.
Charles Bean summarises the views of those calling for a clear separation thus: “I think the structure of the two committees' remits is both fine and clear, with MPC only having an explicit role in dampening financial booms if the FPC judges its instruments are not up to the task and informs the MPC of the same.” Panicos Demetriades (University of Leicester), referring to his latest book (Demetriades 2019), goes further and warns: “Muddling the waters of monetary policy with macroprudential objectives is a recipe for destroying whatever is left of central bank independence.” David Miles elaborates: “interest rate policy is just too blunt an instrument to be the right tool.” With regards to house prices, he warns against using monetary policy to make housing more affordable: “The tools relevant to that are not at all those a central bank has - tax and planning policy are the right instruments.”
Several counterpoints were made by those supporting the use of monetary policy to address financial imbalances. First, David Cobham opines that “we still do not have anywhere near enough experience of macroprudential tools to be sure that we can calibrate them appropriately for all circumstances.” Second, asset prices convey information about the future, as argued by Wouter Den Haan: “It may very well be true that asset prices and especially financial imbalances are usually best addressed using macro prudential tools. But that doesn't mean that they shouldn't play a role in conventional monetary policy decision making. For starters, these factors could affect inflationary pressure.” Finally, Kate Barker adds: “Macroprudential are best for addressing [them] directly - but to ignore financial imbalances and their potential long-run effects when setting monetary policy would be to repeat the error of the mid-2000s.”
References
Adrian, T. and N. Liang, “Monetary Policy, Financial Conditions, and Financial Stability,” International Journal of Central Banking, January 2018.
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Bean, C. “Asset prices, financial imbalances and monetary policy: are inflation targets enough?”, BIS Working Papers No 140, September 2003.
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Bernanke, B. S., and M. Gertler. „Should Central Banks Respond to Movements in Asset Prices?” American Economic Review, 91 (2): 253-257, 2001.
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Caballero, R. J. and A. Simsek, “Prudential Monetary Policy,” Working paper, 2020.
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Cecchetti, S., H. Genberg, J. Lipsky, S. and Wadhwani, “Asset Prices and Central Bank Policy,” Geneva Report on the World Economy no. 2, London: Centre for Economic Policy Research, 2000.
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Cecchetti, S. G., H. Genberg, and S. Wadhwani, “Asset Prices in a Flexible Inflation Targeting Framework,” NBER Working Paper 8970, 2002.
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Cosgrove, P., “Modelling leaning against the wind' of asset price bubbles”, Working Paper, 2017.
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Demetriades, P. Central Bank Independence and the Future of the Euro, Columbia University Press, 2019
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Farmer, R. “Qualitative easing: a new tool for the stabilisation of financial markets”, Bank of England Quarterly Bulletin, 2013 Q4.
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Farmer, R. “Financial Stability and the Role of the Financial Policy Committee”, The Manchester School Supplement 2014: 33-45
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Farmer, R. “The role of financial policy”, Review of Keynesian Economics, Vol. 6 No. 4, Winter 2018, pp. 446–460
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Gali, J. “Monetary Policy and Rational Asset Price Bubbles”, American Economic Review, 104 (3): 721-752, 2014.
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Reis, R. “A dynamic measure of inflation”, University of Columbia Papers, 2009
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Roubini, N. “Why Central Banks Should Burst Bubbles”, International Finance 9(1): 87–107, 2006
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Svensson, L. E. O. “Cost-Benefit Analysis of Leaning Against the Wind,” Journal of Monetary Economics, 90, 2017.
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Wadhwani, S., “Should monetary policy respond to asset price bubbles? Revisiting the debate,” National Institute Economic Review, October 2008.
[1] The author acknowledges Lucile Crumpton for her able research and editorial assistance.
