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.
Table of Contents
1. Introduction
2. Approaches to Asset Price Incorporation
2.1 Direct Targeting of Asset Prices
2.2 Pricking Asset Bubbles
2.3 The Orthodox View
2.4 The "Leaning Against the Wind" Approach
3. Conclusion
Objectives and Topics
The paper examines the role of asset prices in the formulation of monetary policy, specifically evaluating whether central banks should actively respond to asset price fluctuations or speculative bubbles to maintain macroeconomic stability.
- The relationship between asset prices and monetary policy mandates.
- Evaluation of "direct targeting" versus "leaning against the wind" strategies.
- Analysis of the risks associated with pricking asset price bubbles.
- The utility of asset prices as informational signals for consumer price inflation.
- Conditions for effective central bank intervention in financial markets.
Excerpt from the Book
The "Leaning Against the Wind" Approach
In contrast, the “leaning against the wind” approach is based on the idea that macroeconomic performance can be improved by reacting systematically to asset prices misalignments, above and beyond their information about the (future) state of the economy (Cecchetti et al, 2002). There is a rudimentary difference between asset price changes due to fundamentals and changes due to speculative mania and hence policy reactions should be different. Asset price misalignments create distortions in investment and consumption, leading to excessive increases followed by falls in real output and inflation (Cecchetti et al, 2002). The bursting of bubbles has a strong destabilizing effect on the real economy and avoiding bubbles, if possible, is highly desirable. By “leaning against the wind” the size of the bubble can be reduced and the destabilizing effects of the bursting of the bubble will also diminish. Asset price misalignments should not be ignored, solely because it is hard to identify them. Essentially, measuring asset price misalignments is not fundamentally harder than estimating deviations from potential output (Cecchetti et al, 2002).
Summary of Chapters
1. Introduction: This chapter introduces the central problem of balancing price stability with the potential need to account for asset price fluctuations in monetary policy.
2. Approaches to Asset Price Incorporation: This section provides a comprehensive analysis of various monetary policy strategies, comparing direct targeting, bubble-pricking, the orthodox view, and the leaning against the wind approach.
3. Conclusion: The final section synthesizes the arguments, suggesting that while asset prices contain useful information, monetary policy should generally avoid direct targeting or aggressive intervention in favor of a more nuanced approach.
Keywords
Monetary policy, Asset prices, Inflation targeting, Central banks, Financial bubbles, Price stability, Leaning against the wind, Macroeconomic stability, Speculative activity, Interest rates, Informational requirements, Real economy, Financial markets, Asset price misalignments, Economic efficiency.
Frequently Asked Questions
What is the primary scope of this paper?
The paper investigates the extent to which central banks should incorporate asset prices into their monetary policy framework to ensure overall economic stability.
What are the main thematic areas discussed?
The core themes include the definition and identification of asset bubbles, the limitations of monetary policy as a tool for market intervention, and the informational value of asset prices for future inflation.
What is the central research question?
The paper asks whether and how monetary authorities should adjust interest rates in response to asset price movements and potential speculative bubbles.
Which scientific methods are employed?
The work utilizes a qualitative synthesis of established economic literature and theoretical models from prominent economists and central banking institutions.
What is covered in the main body of the text?
The main body evaluates four distinct approaches to asset prices: direct targeting, pricking bubbles, the orthodox view, and the "leaning against the wind" approach.
Which keywords characterize the work?
Key terms include monetary policy, asset prices, inflation targeting, financial bubbles, and macroeconomic stability.
Why is "pricking" asset bubbles considered problematic?
The author notes that identifying bubbles is extremely difficult, and the policy tools available (like interest rate hikes) are often too blunt, risking damage to the broader real economy.
What specific criteria must be met for "leaning against the wind" to be effective?
Effective application requires high confidence in identifying a bubble, sensitivity of the bubble to interest rate changes, and a clear understanding of the potential economic inefficiencies caused by a burst.
- Arbeit zitieren
- Frederik Schröder (Autor:in), 2009, To what extent should monetary policy take asset prices into account?, München, GRIN Verlag, https://www.grin.com/document/189033
