Monetary Policy and Asset Price Booms: A Step Towards a Synthesis

• DOI: http://doi.org/10.1111/infi.12081
• Author: Sohei Kaihatsu,Takaaki Kurebayashi,Takushi Kurozumi,Hiroshi Fujiki
• Date: 01 April 2016
• Published date: 01 April 2016

Monetary Policy and Asset Price

Booms: A Step Towards a

Synthesis

Hiroshi Fujiki

y

, Sohei Kaihatsu

z

,

Takaaki Kurebayashi

z

and Takushi Kurozumi

z

y

Chuo University, Tokyo, Japan, and

z

Bank of Japan, Tokyo, Japan.

Abstract

Should a monetary policy maker following a Taylor-type rule set a higher

policy rate than the level suggested by the rule because of a possibility of

an asset price bust in the near future? Our answer to this question for

monetary policy makers who have two scenarios of ‘boom–bust cycle’and

‘stable growth’is yes if the following two conditions are satisfied. First,

early warning indicators based on credit and residential investment data

show a high probability of a boom–bust cycle occurring. Second, the

policy rate path that minimizes the boom–bust probability-based ex-

pected value of a social loss associated with inflation and the output gap

over the two scenarios is higher than the rate path by the Taylor-type rule.

Our counterfactual analysis shows that the Fed should have raised the

federal funds rate by a small amountover and above the level suggested by

a Taylor-type rule in the early 2000s.

The authors are grateful to Toni Braun, Lavan Mahadeva, Adrian Pagan, Fra ncesco Zanetti, the editor

Benn Steil, the editor’s assistant Andrew Hende rson, colleagues at the Bank of Japan, an onymous

referees and partic ipants at the Ban k of England Workshop on Modelli ng Monetary Polic y and the

Federal Reserve Bank of Kansas Cit y seminar. The views expressed in this paper are th ose of the

authors and do not necess arily reflect the official views of the Bank of Japan.

International Finance 19:1, 2016: pp. 23–41

DOI: 10.1111/infi.12081

© 2016 John Wiley & Sons Ltd

I. Introduction

The recent asset price bust and the su bsequent severe economic downtur n around

the globe have provoked critical di scussions regarding t he validity of a dominant

view on the age-old quest ion: how should monetary policy react to asse t price

developments? Prior to the recent downturn, t he dominant view –the so-called ‘Fed

view’–provided the following t wofold answer.

1

First, monetar y policy shoul d not

respond to asset price de velopments unless they influence policy makers’outlook on

inflation and economic ac tivities. Second , once an asset price bust occ urs, monetary

policy should reac t aggressively to the subsequent downturn ( that is, the ‘clean up

the mess’strategy). In contrast, econom ists at the Bank for Internati onal Settlements

(BIS) argued that, to prevent asset pr ice boom–bust cycles, m onetary p olicy makers

should adopt the ‘lean against the wind’strateg y, which sets a higher polic y rate

than Taylor (1993)-type rules designed to achieve price stability.

2

Their views –the

so-called ‘BIS view’–are based on the belief that monetar y policy m akers should

consider the risk that an asset price boom during a period of stable inflation could

result in its bust.

3

In the aftermath of the recent global recession, many central bank officials have

pointed to limitations of the dominant view. Former European Central Bank (ECB)

President Trichet (2009) and former ECB Executive Board Members Bini Smaghi (2009)

and Stark (2009) stressed that monetary policy conduct relying on the clean-up-the-

mess strategy has clear limitat ions. Even among Fed officials, former FRB Vice

Chairman Kohn (2008), Chicago Fed President Evans (2009), former San Francisco

Fed President (and current FRB Chair) Yellen (2009) and New York Fed President

Dudley (2010) have stated that the potential gain from preventing asset price boom–

bust cycles may turn out to be far greater than it was once thought to be.

One may reasonably wonder wh ether the huge cost of th e recent global downturn

will convince monetar y policy makers that they should take the B IS view seriously.

However, there are two difficulties as follows: (i) it may be difficult to identify asse t

price boom–bust cycles in a timely ma nner, as Fed officials argu e; and (ii) even if

such cycles can be ide ntified, monetar y policy is a b lunt tool for preventing them,

and thus it may be d ifficult to deter mine to what extent the policy rate should be

raised. The lack of agree d-upon ways to overcome these two difficulties h as so far

led to debates b etween the two c amps.

This paper seeks to contribute to the debate between the BIS view and the Fed

view by proposing an operational monetary policy framework that helps

1

See, e.g. Kohn (2006).

2

See, e.g. Borio and White (20 03) and White (2006, 2009) .

3

Christiano et al. ( 2010) indicate that the U S stock price booms arose under s table inflation during

the past century.

24 Hiroshi Fujiki et al.

© 2016 John Wiley & Sons Ltd