IMF Institute seminar: Cecchetti argues asset price considerations should play role in shaping monetary policy

Should central banks take asset prices into account when they formulate monetary policy? The question often comes to the fore during financial market turbulence or marked changes in asset market valuations. Not surprisingly, it is again topical against the background of the extended fallout from the housing and equity bubbles of the late 1980s in Japan, the crises in southeast Asia in 1997–98, and the run-up in U.S. equity valuations. Addressing this subject at an IMF Institute seminar on September 11, Professor Stephen Cecchetti of Ohio State University argued for a more systematic incorporation of asset prices into monetary policy decisions. His presentation was based on a recent study that he coauthored, 2000, Asset Prices and Central Bank Policy (Geneva Report on the World Economy, No. 2).

Abstract

Should central banks take asset prices into account when they formulate monetary policy? The question often comes to the fore during financial market turbulence or marked changes in asset market valuations. Not surprisingly, it is again topical against the background of the extended fallout from the housing and equity bubbles of the late 1980s in Japan, the crises in southeast Asia in 1997–98, and the run-up in U.S. equity valuations. Addressing this subject at an IMF Institute seminar on September 11, Professor Stephen Cecchetti of Ohio State University argued for a more systematic incorporation of asset prices into monetary policy decisions. His presentation was based on a recent study that he coauthored, 2000, Asset Prices and Central Bank Policy (Geneva Report on the World Economy, No. 2).

Should central banks take asset prices into account when they formulate monetary policy? The question often comes to the fore during financial market turbulence or marked changes in asset market valuations. Not surprisingly, it is again topical against the background of the extended fallout from the housing and equity bubbles of the late 1980s in Japan, the crises in southeast Asia in 1997–98, and the run-up in U.S. equity valuations. Addressing this subject at an IMF Institute seminar on September 11, Professor Stephen Cecchetti of Ohio State University argued for a more systematic incorporation of asset prices into monetary policy decisions. His presentation was based on a recent study that he coauthored, 2000, Asset Prices and Central Bank Policy (Geneva Report on the World Economy, No. 2).

Central bankers keep a keen eye on asset price developments and sometimes act in response to these developments. But Cecchetti noted that the predominant view among central bankers and academics is that central banks should set interest rates in response to actual or forecast inflation, and possibly also in response to the output gap, but should not react systematically to asset price developments. This view holds that asset prices are too volatile to be used in policy formation, that asset price misalignments are difficult to identify, and that reacting to such misalignments may be destabilizing.

Cecchetti took issue with these views. He argued that central banks are likely to achieve superior performance by explicitly taking account of asset prices in setting monetary policy. He also made the case for giving some asset prices, notably housing prices, a larger weight in inflation measures.

Case for including asset prices

According to Cecchetti, asset price changes influence aggregate demand through wealth effects on consumption; through the impact on firms’ balance sheets, which in turn affect firms’ ability to borrow; and through the second-round effects of changes in aggregate demand on asset prices. Where asset price changes reflect underlying productivity growth in the economy, demand-side effects may be broadly matched on the supply side, with little need for a reaction from monetary policy. However, when price changes originate in asset markets, the central bank may need to take action to counter the effects on inflation. This could arise, for example, with a change in the equity risk premium, which is the difference between the return that investors require on equities relative to bonds.

Cecchetti focused on misalignments in asset prices. These occur when prices diverge from what is warranted by underlying productivity and by sustainable values of the equity risk premium. When misalignments are reversed—when bubbles burst—there can be significant economic damage. He suggested that central banks could improve economic performance (measured as the variability of inflation and output around goals) by leaning against emerging asset price misalignments, even if this caused a short-term deviation from the inflation goal. Such a deviation is warranted to the extent that the benefits of avoiding the future consequences of a large asset price misalignment outweigh the short-term costs of deviating from the inflation goal.

A policy rule that explicitly includes asset prices would limit moral hazard problems by underlining that monetary policy would react symmetrically to asset price movements. At present, Cecchetti said, it is widely believed that the monetary authorities are more concerned about abrupt price declines than about sudden price increases. This impression may, however, have more to do with skewed data (abrupt changes tend to occur more frequently on the downside) than with any bias in central bank policy.

Concerns about including asset prices

Cecchetti discounted concerns that his approach would cause instability. He was not, he said, recommending pricking bubbles but leaning against the wind at an earlier stage to inhibit the emergence of bubbles. Moreover, if central bank action to rein in asset prices led to excessively sharp corrections, the same systematic rule would, at an early stage, prompt a countervailing response. The focus should be on the relevance of asset prices to the overall monetary policy strategy, he stressed.

The argument is frequently made, Cecchetti asserted, that central bankers have no expertise in asset pricing, and market expectations are unobservable. Estimating asset price misalignments is indeed difficult, but no more difficult, he said, than other calculations that central bankers make on a regular basis, such as estimating the level of potential output and its growth rate, the natural rate of unemployment, and the neutral real interest rate. Indeed, the productivity growth rate—a key input for estimates of asset price misalignments—is also essential in estimating the growth rate of potential output.

Implications for U.S. monetary policy

If the United States had adopted this strategy in the recent past, Cecchetti explained, it would have had to set higher short-term interest rates. The equity risk premium has been at the lower end of its historical range, but surveys indicated that equity holders expected annual returns of 10–12 percent—significantly higher than implied by the equity risk premium. This suggested above-average risk to holding U.S. equities.

He illustrated the implications for U.S. monetary policy with a “Taylor Rule”—a frequently used means of relating short-term interest rates to inflation and the output gap. According to this rule, a federal funds rate of 6½ percent would have been appropriate for the last quarter of 1999. If this rule is augmented to include a link between interest rates and asset price misalignments, a rate closer to 7½ percent would have been indicated for that quarter. In actuality, the rate over that period averaged about 5¼ percent.

Cecchetti stressed the illustrative nature of this exercise. Greater modeling efforts would be needed before this approach could be implemented, and such rules are not, in any case, meant to be mechanically applied. He also noted that a central purpose of his proposed approach was to limit the emergence of asset price misalignments. Thus, the implications of adopting the approach are exaggerated at a time when asset prices may already be significantly misaligned.

Improving measures of inflation

Cecchetti then turned to the question of whether including asset prices could improve measures of inflation. The measures used by central bankers typically cover only the prices of goods and services currently produced. In 1973, Armen Alchian and Benjamin Klein argued that the central bank should maintain the stability of the purchasing power of money—a concept that would incorporate the price of future as well as current consumption. With such an approach, asset prices could be used to measure the price of future consumption. Because current consumption was small in relation to future consumption for the typical individual, current consumption would be given a small weight. Cecchetti doubted that an approach to monetary policy that effectively targeted asset prices could be generally accepted. More substantively, asset prices move around considerably in response to factors that have little to do with inflationary trends.

An alternative approach, Cecchetti suggested, could be based on the idea that all prices, including asset prices, have a common core component that represents aggregate inflation. He proposed a statistical method for extracting this core component from equity and housing prices as well as prices for consumer goods and services. Using data for a range of industrial countries, he concluded that equity prices are generally too noisy to communicate useful information about general inflation, but that housing prices merit a higher weight than they are typically given in consumer price indices.