Cecchetti argues asset price considerations should play role in shaping monetary policy

• Author: Donogh McDonald
• Position: IMF Institute
• Pages: 346-347

Page 346

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...