Asset Prices and Monetary Policy

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.

Proposition 2: Asset prices and financial imbalances are best addressed using macroprudential tools and left out of the monetary policy decision making process.

 

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.

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. 

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.

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

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. 

Bean, C. “Asset prices, financial imbalances and monetary policy: are inflation targets enough?”, BIS Working Papers No 140, September 2003. 

Bernanke, B. S., and M. Gertler. „Should Central Banks Respond to Movements in Asset Prices?” American Economic Review, 91 (2): 253-257, 2001.

Caballero, R. J. and A. Simsek, “Prudential Monetary Policy,” Working paper, 2020.

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.

Cecchetti, S. G., H. Genberg, and S. Wadhwani, “Asset Prices in a Flexible Inflation Targeting Framework,” NBER Working Paper 8970, 2002.

Cosgrove, P., “Modelling leaning against the wind' of asset price bubbles”, Working Paper, 2017.

Demetriades, P. Central Bank Independence and the Future of the Euro, Columbia University Press, 2019

Farmer, R. “Qualitative easing: a new tool for the stabilisation of financial markets”, Bank of England Quarterly Bulletin, 2013 Q4.

Farmer, R. “Financial Stability and the Role of the Financial Policy Committee”, The Manchester School Supplement 2014: 33-45

Farmer, R. “The role of financial policy”, Review of Keynesian Economics, Vol. 6 No. 4, Winter 2018, pp. 446–460

Gali, J. “Monetary Policy and Rational Asset Price Bubbles”, American Economic Review, 104 (3): 721-752, 2014.

Reis, R. „A dynamic measure of inflation“, University of Columbia Papers, 2009

Roubini, N. “Why Central Banks Should Burst Bubbles”, International Finance 9(1): 87–107, 2006

Svensson, L. E. O. “Cost-Benefit Analysis of Leaning Against the Wind,” Journal of Monetary Economics, 90, 2017.

Wadhwani, S., “Should monetary policy respond to asset price bubbles? Revisiting the debate,” National Institute Economic Review, October 2008.

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How the experts responded

Question 1

Participant Answer Confidence level Comment
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme Strongly disagree Very confident
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.
Michael McMahon's picture Michael McMahon University of Oxford Disagree Confident
Though I disagree that house prices (or other asset prices) should be the target, I acknowledge that there is a difficulty for central bank. The general public that they serve see 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.
David Cobham's picture David Cobham Heriot Watt University Strongly agree Very confident
The Bank's *monetary policy remit* should cover the right to focus policy temporarily on house prices (but not any other asset prices, they're too volatile and less closely related to social welfare) if and only if the macroprudential tools don't seem to be being effective. And it is essential that this should be known and understood by the public, so that the possibility of interest rate or other monetary policy decisions being aimed at house prices is factored into expectations of house prices. What the Cosgrove paper shows is that, under reasonable assumptions about expectations and asset prices and in the context of a wide range of arbitrary shocks, an 'activist' strategy which affects expectations leads to less volatile inflation, output and asset prices than a 'sceptic' strategy which pays no attention to asset prices.
Patrick Minford's picture Patrick Minford Cardiff Business School Disagree Confident
The target of monetary policy is controlling inflation and stabilising output over the business cycle. Our research on an estimated model of the UK suggests that this is done well by the current framework, though it could be improved by targeting nominal GDP. Housing and asset prices introduce targets that cut across this more general information.
Francesca Monti's picture Francesca Monti Kings College London Disagree Very confident
The risk here is mission creep. Adding an explicit reference to house prices or asset prices in the mandate would make the Bank's policies less easy to understand and interpret, so I would avoid it. The Bank should certainly consider also asset prices in their decision making, insofar as they affect their objectives (inflation target, financial stability, etc...)
Jumana Saleheen's picture Jumana Saleheen CRU Group Agree Very confident
The relationship between house prices and monetary policy - "It's complicated". That is why I agree that house prices should receive special attention in monetary policy decisions. 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. We know housing booms tend to proceed larger recessions. And that low for long fuels can fuel housing booms.
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Disagree Confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Agree Confident
Wouter Den Haan's picture Wouter Den Haan London School of Economics Strongly disagree Not confident
I would think that the current mandate already allows "to take into account" asset prices. But when and how they should be taken into account in achieving the Bank's objectives should be left to the monetary policy committee. Asset prices shouldn't be an objective in itself like inflation, overall economic activity and financial stability.
Roger Farmer's picture Roger Farmer University of Warwick Strongly disagree Extremely confident
My answer is contingent on the recognition that the Bank has more than one policy instrument. 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.
Ricardo Reis's picture Ricardo Reis London School of Economics Disagree Very confident
The Bank can (or not) respond to asset prices more (or less) than it does right now, without needing to change the remit, as recently re-stated: https://www.bankofengland.co.uk/-/media/boe/files/letter/2021/march/2021-mpc-remit-letter.pdf If a change were to occur, it might be better 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: https://personal.lse.ac.uk/reisr/papers/99-dpi.pdf )
David Miles's picture David Miles Imperial College Disagree Confident
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. Even if one could do so, using monetary policy (the central bank's policy rate) to eradicate the divergence from the fundamental value is deeply problematic when often the policy rate needed to keep consumer price inflation stable would be very different. A better strategy is to use macro-prudential instruments to reduce the risks that asset price mis-alignment bring economic instability.
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Strongly disagree Extremely confident
The Bank's mandate should not be changed. It should still use interest rates to target inflation on the principle that the number of targets requires at least as many instruments. Adding an extra target - asset prices - would not therefore be consistent with this. However, there is no reason why the Bank should not be conscious of the effect on financial asset prices of its other instrument - quantitative easing. A further problem with targeting house prices is that it is a real asset and is affected by supply - which the Bank has little control over - as well as demand, which interest rates would affect. I would not be in favour of the Bank using interest rates to control housing demand as this is likely to be inconsistent with its inflation target.
Linda Yueh's picture Linda Yueh London Business School Disagree Confident
Costas Milas's picture Costas Milas University of Liverpool Disagree Not confident
The Bank of England already targets CPI inflation but also takes into account how output moves relative to its long-term growth. If asset prices were also to be targeted, the natural question is "which asset price"? House prices, stock prices or, even, the exchange rate? I do not think we will (ever) end up with a clear measure of (combined) asset prices to target; let alone what the point target or target range might be...
Federica Romei University of Oxford Neither agree nor disagree Very confident
From one side, if we increase the number of targets, it is going to be difficult for the central bank to achieve them. On the other side, housing is extremely important for households and demand stabilization. However, the same target can be achieved with some unconventional tools, like macroprudential policies.
Natalie Chen's picture Natalie Chen University of Warwick Disagree Confident
Sir Charles Bean's picture Sir Charles Bean London School of Economics Strongly disagree Extremely confident
I think the present formulation of the remit (which has been in place since 2013) is just fine. 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'). So the MPC should only be expected to aim off its inflation target to deal with an asset-price boom if the FPC judges its instruments are not up to the task. In addition, adding an explicit house-price objective would muddy the waters (I have no objection to MPC targeting an inflation measure that includes a suitable housing element, such as CPIH). Furthermore, house prices often move for other reasons, such as fiscal measures, and it would seem inapproriate to expect MPC to seek to prevent such movements.
Panicos Demetriades's picture Panicos Demetriades University of Leicester Strongly disagree Extremely confident
Asset prices should be dealt with macroprudential regulation and tools. Macroprudential policy is now well defined and central banks can use it to address asset price growth that threatens to create financial instability. Within Basel III, there are various macroprudential tools that can help contain asset price growth, such as countercyclical capital requirements and leverage ratio. If macroprudential policy is failing to use them, for whatever reason, it is not the job of monetary policy makers to assist. Monetary policy should only respond to asset price growth to the extent that it affects core inflation. There is one dimension of asset price growth that economists often ignore - the political economy dimension. Asset price growth makes the wealthy wealthier. Often ruling elites create obstacles to appropriate macroprudential policies. However, getting help from monetary policy makers to address asset price growth is wrong: it would make monetary policy more political than necessary. Central bank independence, which is at the heart of the success of inflation targeting, could be at risk if monetary policy becomes more political. In other words, two wrongs do not make a right. Macroprudential policy needs to be strengthened and protected from political interests. Monetary policy should remain apolitical.
Lucio Sarno's picture Lucio Sarno Cambridge University Agree Confident
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Disagree Confident
I don't think there is sufficient consensus on this topic to formalize this policy as a rule.

Question 2

Participant Answer Confidence level Comment
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme Strongly disagree Extremely confident
Macroprudential are best for addressing 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.
Michael McMahon's picture Michael McMahon University of Oxford Agree Very confident
Though the information from financial balances can be important inputs into the monetary policy process - for example, because it can provide information on the transmission of monetary policy through the banking system.
David Cobham's picture David Cobham Heriot Watt University Disagree Very confident
They should be FIRST addressed with macroprudential tools, but there should always be a 'backstop' available in the form of monetary policy actions. We still do not have anywhere near enough experience of macroprudential tools to be sure that we can calibrate them appropriately for all circumstances.
Francesca Monti's picture Francesca Monti Kings College London Agree Very confident
Monetary policy tools are less effective in addressing financial imbalances than macroprudential tools.
Patrick Minford's picture Patrick Minford Cardiff Business School Agree Confident
agreed basically. My proviso would be that macroprudential tools should not be used at all, since they interfere with and distort market-based decisions by households and firms.
Jumana Saleheen's picture Jumana Saleheen CRU Group Neither agree nor disagree Confident
Propostiion 2 is the post-GFC consensus. The jury is still out on how successful the post-GFC framework has been. The understanding of macro prudential policy is still very low amoung the general public.
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Agree Confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Disagree Confident
Wouter Den Haan's picture Wouter Den Haan London School of Economics Disagree Not confident
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.
Roger Farmer's picture Roger Farmer University of Warwick Strongly disagree Extremely confident
The FPC should be given the mandate, and the tools, to directly stabilize the rate of growth of asset prices. But making this decision can be and must be coordinated with the MPC, whose remit is price stability. I explain this coordinated policy option in a series of books and paper that can be accessed on my website rogerfarmer.com. The simplest introduction is to be found in my book, Prosperity for All, published by Oxford University Press in 2016 and available on Amazon Kindle.
Ricardo Reis's picture Ricardo Reis London School of Economics Disagree Very confident
They should not be left our to the monetary policy decision process, even if macrprudential tools are the first line of defense.
David Miles's picture David Miles Imperial College Agree Confident
Central banks do have a big role in maintaining financial stability and asset price gyrations can create problems. But interest rate policy is just too blunt an instrument to be the right tool. As regards house prices, one spectacularly mis-guided direction to go would be to give the central bank a target for house prices as a means to increase affordability. The tools relevant to that are not at all those a central bank has - tax and planning policy are the right instruments. .
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Agree Confident
See first answer. Best addressed? Yes. But this doesn't necessarily imply it is possible to do so effectively. For example, if a rise in house prices is due to supply shortages, monetary policy, which acts on mainly on demand, at best suppresses the problem and at worst would be ineffective. The Bank might have more success in influencing financial asset prices. A start would be to stop inducing portfolio substitution by keeping interest rates so low and by buying government bonds from the private sector.
Linda Yueh's picture Linda Yueh London Business School Neither agree nor disagree Confident
Paul De Grauwe's picture Paul De Grauwe London School of Economics Disagree Confident
Costas Milas's picture Costas Milas University of Liverpool Agree Confident
You made the case loud and clear. Nothing more to add here!
Federica Romei University of Oxford Agree Very confident
Using more unconventional tools can expand the instruments of the central bank. Therefore, it is going to be easy to achieve the target.
Natalie Chen's picture Natalie Chen University of Warwick Agree Confident
Panicos Demetriades's picture Panicos Demetriades University of Leicester Strongly agree Extremely confident
Yes. Please see my previous answer. Muddling the waters of monetary policy with macroprudential objectives is a recipe for destroying whatever is left of central bank independence. For further details, please see my latest book: Central bank independence and the future of the Euro, Agenda Publishing, 2019.
Sir Charles Bean's picture Sir Charles Bean London School of Economics Agree Very confident
As already indicated, 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.
Lucio Sarno's picture Lucio Sarno Cambridge University Neither agree nor disagree Not confident
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Strongly disagree Confident
There is only so much that macroprudential tools can do and it is important to keep the door open to the "sledgehammer" of interest rate policy that might be needed to rein in financial excesses.