Essay, 2009, 7 Pages
University of Otago, Grade: A
Monetary policy makers set policy in order to minimize deviations of actual inflation from some predetermined level while paying attention to deviations of output from potential. The extent to which asset prices should be taken into account, when setting policy aimed at achieving the desired goal, has moved into the focus of academic debate, as low and stable consumer price inflation (at least in OECD countries) has been achieved. There are several distinct possibilities regarding how asset prices can be incorporated when determining the interest rate (or the money supply). Two extreme approaches that can be taken are specifically targeting asset prices and "pricking asset bubbles" upon their emergence. These views however, have been rejected with sufficient consensus (Isssing, 2009). More moderate alternatives are the "leaning against the wind" approach and the orthodox view. "Leaning against the wind" implies tolerating a certain deviation from price stability while simultaneously attempting to prevent the emergence of a bubble (Kohn, 2006). The orthodox view says that asset prices should be ignored beyond their impact on consumer price inflation. When strong informational requirements and specific conditions are met, however, an argument for the "leaning against the wind" approach can be made. The probability that a bubble is correctly identified must be high, the future growth of the bubble needs to be sensitive to interest rates and the economic inefficiencies arising from a burst of the bubble should rise with the size of the bubble (Trichet, 2005). However, if these conditions are not met, central banks are likely to achieve higher macroeconomic stability by following the orthodox approach.
It is widely agreed upon that central banks should maintain price stability by keeping inflation low and stable. Relatively recent movements towards more independent central banks with such a mandate confirm this theory. The functions of money, unit of account, medium of exchange and store of value are best preserved when a stable consumer price index of some sort maintains the real value of money (Issing, 2009). The central bank should, so the argument for targeting asset prices goes, be concerned with stable prices for current and future consumption goods by focusing on a "cost-of-life index" proxied by asset prices (ECB, 2005). However, targeting asset prices directly, or in other words, including asset prices in the measure of inflation can be undesirable for several reasons (Issing, 2009).
Firstly, asset prices are likely to be a bad proxy for future inflation, because asset prices can move in directions unrelated to expected future inflation. If asset price inflation is to be measured, the fundamentals need to be known and furthermore the difficulties in their measurement must be successfully overcome. Secondly, targeting asset prices creates a moral hazard problem with regards towards risk. Risk taking will increase with the anticipation of the central bank's efforts to stabilize the asset price (Goodhard & Huang, 1999). Thirdly, a circular relationship between asset prices and monetary policy may arise as asset prices are affected by monetary policy whilst monetary policy partly determines asset prices at the same time. Inflation expectations would become self fulfilling, indeterminate and potentially very volatile (Bernanke & Woodford, 1997). Additionally, if the central bank successfully targets a measure of consumer prices and takes into account the information asset prices contain, then specifically targeting asset prices will result in double counting inflationary pressures derived from asset prices (Bernanke & Gertler, 2001). Furthermore, the weight of the asset prices in the central banks' loss function is ambiguous. The weights may be very high if they were based upon traditional expenditure shares (ECB, 2005). Finally, the fundamentals of assets are outside the control of the central banks and thus targeting asset prices may turn out to be ineffective. These reasons lead to the conclusion that central banks should not target asset prices directly.
Another extreme option is for central banks to prick asset price bubbles using monetary policy. Being able to prick a bubble implies knowing of the existence of such a bubble. Such knowledge, however, cannot always be taken for granted. If investors were perfectly forward looking rational agents, then asset prices should reflect the present value of expected future earnings adjusted for a risk premium.
These fundamentals, however, are not only hard to measure - partly because they are not observable - but there may also be different views regarding the appropriate valuation of asset prices (ECB, 2005). Bubbles are easily recognizable once they burst, however during their sometimes slow emergence, they are very difficult to identify. Even if monetary authorities are able to successfully spot an asset price bubble, their policies are "far too blunt of a tool for effective use against them" (Bernanke, 2002). In order to successfully destroy asset bubbles using monetary policy, sharp interest hikes are necessary. Such interest hikes, however, would not leave the broader economy untouched (Bernanke, 2002). Policy makers would be faced with the difficulty of determining which asset prices (such as exchange rates, real estate, equity) should be included. Economists have thus come to the consensus that attempts to prick asset price bubbles may pose serious risks to the economy and hence should not be pursued. In summary, it can be seen that two ways of including asset prices in monetary policy should be rejected. Mechanically reacting to all asset price changes as well as attempting to prick asset bubbles should not be part of any central banks' objective.
A widely accepted approach of dealing with asset prices is the orthodox view. This view posits that asset prices should only be taken into account in so far, as they dispose information about expected inflation (Bernanke & Gertler, 2001). As with pricking asset price bubbles, identifying the existence of the bubble is seen as a major problem. An increase in stock prices may be due to a positive productivity shock but alternatively it may stem from a financial bubble. Any available information should be used when making predictions about the state of the economy. This includes asset price signals from financial and real estate markets. Asset prices affect the real economy through standard wealth effects as well as through the balance sheet channel (Bernanke & Gertler, 1999). Agents may use assets as collateral when borrowing. Hence, a decline in asset values reduces collateral and limits potential borrowers' access to credit. Falling asset prices decrease consumers' wealth, and together with the balance sheet effect, reduce inflationary pressures through aggregate demand effects.
 These goals may not be explicitly stated, but implicitly any central bank has these two objectives in mind. Low and stable inflation is consistent with output at its potential.
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