In a highly influential paper, Bernanke and Gertler (1999) started the debate on how monetary policy should react to asset price fluctuations. A decade and two recessions later, it is a good time to take stock of the recent empirical and theoretical advances on this debate. This article discusses three questions: first, what is the evidence on the effects of asset prices (including housing prices) on the macro economy? Second, how can monetary policy mitigate the effects of asset prices fluctuations? And third, what other policy options can be used to prevent and exit a financial and banking crisis like the one suffered during 2007–09.

Abstract

In a highly influential paper, Bernanke and Gertler (1999) started the debate on how monetary policy should react to asset price fluctuations. A decade and two recessions later, it is a good time to take stock of the recent empirical and theoretical advances on this debate. This article discusses three questions: first, what is the evidence on the effects of asset prices (including housing prices) on the macro economy? Second, how can monetary policy mitigate the effects of asset prices fluctuations? And third, what other policy options can be used to prevent and exit a financial and banking crisis like the one suffered during 2007–09.

Policymakers should be concerned about asset price fluctuations because of the effect they have on general macroeconomic goals such as sustainable growth, employment, inflation, and, hence, welfare. Maintaining financial stability is also important because it is a necessary condition for stable growth and job creation. There are several channels through which asset prices affect these variables. First, a rise in asset prices also increases households’ financial wealth and a fraction of those capital gains are spent on consumption. A conventional estimate of the wealth effect is that an increase in wealth of $1 leads to an increase in consumption of 5 cents (Lettau and Ludvigson, 2004).

A second channel through which asset prices affect spending is through the relaxation of credit constraints. The relationship between asset prices and borrowing constraints at the firm level is at the core of Bernanke and Gertler’s (1999) “financial accelerator” model: increased asset prices improve the balance sheet of firms and reduce their probability of default, thereby reducing risk premia and the cost of external funds. On the household side, increased house prices allow homeowners to borrow against the value of their housing collateral, and hence increase consumption in other goods. Due to the large boom-bust cycles in housing prices that many advanced countries have experienced in the 2000s, and to the increased importance of financial products that allow for mortgage equity withdrawal, this effect has attracted a lot of attention in the recent literature (Mian and Sufi, forthcoming). The impact of house price fluctuations on credit constraints has also been examined using the latest generation of dynamic stochastic general equilibrium (DGSE) models (Iacoviello and Neri, forthcoming; Notarpietro and Darracq-Parriès, 2009).

Last but not least, the most important consequence of declining asset and house prices during the 2007–09 financial crisis was to impair the capability of the financial sector to effectively provide funds to the rest of the economy. As Adrian and Shin (2008) point out, the importance of broker-dealers with respect to the traditional banking system increased in recent years. As a result, the stock of home mortgages in the United States is now dominated by the holdings in market-based institutions, rather than traditional banks’ balance sheets. The effect of the decline of asset and house prices on financial institutions’ balance sheets leads to a negative feedback loop between deleveraging, tightened financial conditions, freezing of credit markets, output losses, and further asset price deflation.

Bernanke and Gertler (1999) asserted that monetary policy should not respond to asset price fluctuations, but rather respond only to the consequences of asset price fluctuations on inflation and output. The main argument was that it was difficult to distinguish a speculative bubble from a productivity shock in the initial stages, as they both lead to high growth and increased asset prices. Given this uncertainty it is therefore better to not “lean against the wind.” If it turns out that asset prices were driven by a bubble, then the central bank should “clean up the mess” when the bubble bursts. Another argument is that, in order to be able to burst a bubble, the central bank would have to raise interest rates to a level that could be seriously destabilizing for the rest of the economy (Buiter, 2009).

Recent research has suggested that it is possible to improve welfare by including asset price fluctuations or indicators of financial vulnerability in the monetary policy rule. The IMF (2009) and Kannan, Rabanal, and Scott (2009) have examined the role of reacting to excessive credit growth in a model where housing collateral alleviates credit constraints. They find that reacting to nominal credit growth in the Taylor rule improves welfare when the economy is facing a relaxation of credit standards, but that under productivity shocks a standard Taylor rule performs well. Christiano and others (2007) have also found policy improvements in a large- scale DSGE model when the Taylor rule targets nominal credit growth. Introducing credit spreads in the monetary policy rule can help alleviate the effects of tightening conditions in financial markets (Cúrdia and Woodford, 2009).

However, using the benchmark rate of the central bank as a tool to also address financial sector imbalances might be asking too much from monetary policy. Other proposals suggest that monetary policy should be used to just stabilize inflation and output fluctuations, and that regulatory or macroprudential policy should address vulnerabilities in the financial sector. The IMF (2009) examines the role of a macroprudential instrument that allows regulators to affect conditions in the credit markets. Other proposals for macroprudential policy include Gruss and Sgherri (2009), who assume that the regulatory agency can directly affect the loan-to-value ratio and hence counteract the effects of an asset price boom. However, it remains an open question as to how effective these measures are from a quantitative point of view. For example, Spain’s banks operate under dynamic provisioning rules, but this did not prevent the Spanish economy from going through a large, credit-fueled, boom-bust cycle in housing prices (Aspachs-Bracons and Rabanal, 2008).

Finally, given the severity of the recent crisis, other papers have looked at policy options when financial activity freezes completely and the economy is trapped in a downward spiral of declining asset prices, sharp deterioration of key financial intermediaries’ balance sheets, credit freezes, and widespread panic (a situation that Caballero, forthcoming, calls a “sudden financial arrest”). Within a DSGE modeling framework, Gertler and Karadi (2009) have proposed that the central bank act as an intermediary by lending directly to investors in periods of financial distress when the balance sheet of financial intermediaries is impaired by low asset values. They also show that this type of policy conducted by the central bank is even more powerful when interest rates are at zero, as is currently the case in the United States and Japan.

Bebchuk and Goldstein (2009) note that the recent banking crisis was not a bank run by depositors, but rather a run by commercial banks on investment projects, despite the injection of massive liquidity into the system. In order to get the economy out of such a credit freeze, the policy options are as follows, in increasing order of effectiveness: lower interest rates, capital injections to banks, direct lending to firms by the government, and finally, the use of government funds to finance investments, but channeled through private firms. The last option is the best one, since it takes advantage of the private sector’s expertise in screening the quality of the projects and the public sector’s capacity to obtain funding. Benmelech and Bergman (2009) study similar policy options in a model whose main mechanism hinges on a feedback loop between collateral values, lending, and liquidity in the corporate sector. In order to get out of a credit market freeze, the government lends directly to firms and a large-scale operation might be needed to lift asset prices and jumpstart the economy. Caballero (forthcoming) proposes an insurance mechanism that puts a floor price on assets during a financial crisis, which helps stop fire sales of assets and hence a downturn in the economy that leads to a full-blown panic.

Ultimately, most of the policy proposals since the recent crisis suggest that monetary policy should not target asset prices in the boom part of the cycle, and that stronger regulatory frameworks would help (Bernanke, 2010). However, when asset prices collapse, policymakers should act forcefully to avoid negative feedback loops between the financial sector and real activity.

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