Financial Condition Index and interest rate settings: a comparative analysis

In the last thirty years, there has been a widespread move towards financial liberalisation, both within and across national borders. This economic development brought researchers to investigate the link between asset prices, inflation and the conduct of monetary policy. Starting from the seminal work of Alchian and Klein (1973) it is often argued that the forward-looking nature of asset prices makes them good proxies for the information left out of conventional inflation measures. It is also widely accepted that asset price inflation developments are closely associated with general inflation trends. This paper investigates the role of asset prices in the conduct of monetary policy in United States, Canada, Euro Area and United Kingdom. It has two focal points. First, we construct Financial Condition Indexes for four countries using the Kalman Filter algorithm. This methodology allows us to capture the changes of the weights associated with each financial variable in explaining the output gap over time. Second, we proceed by estimating forward-looking Taylor rules augmented for FCI. Our results suggest that the Financial Condition Index enter positively and statistically significant into the FED, Bank of England and Bank of Canada interest rate setting. This gives a positive view for the use of the FCI as an important short term indicator to guide the conduct of monetary policy in three out of four countries analyzed.Financial Condition Index, Optimal Monetary Policy, Taylor rule.

FINANCIAL CONDITION INDEX AND INTEREST RATE SETTINGS: A COMPARATIVE ANALYSIS

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Optimal Monetary Policy and Asset Price Misalignments

This paper analyses the relationship between monetary policy and asset prices in the context of optimal policy rules. The transmission mechanism is represented by a linearized rational expectations model augmented for the effect of asset prices on aggregate demand. Stabilization objectives are represented by a discounted quadratic loss function penalizing inflation and output gap volatility. Asset prices are allowed to deviate from their intrinsic value since they may be positively affected by past price changes. We find that in the presence of wealth effects and inefficient markets, asset price misalignments from their fundamentals should be included in the optimal interest rate reaction function.

Credit, asset prices and monetary policy

This thesis was submitted for the degree of Doctor of Philosophy and awarded by Brunel University.The developments in asset markets have influenced researchersto focus on the interaction between monetary policy and the financial system. In Chapter I we provide an overview of the role of the financial system for the whole economy. We show the importance of this sector in transmitting the monetary policy actions. The aim of this research is twofold; firstly we want to investigate how important the amount of credit for the whole economy is. To accomplish this objective, in Chapter 2 we make use of the VAR technique to study the monetary transmission mechanism. In particular we are interested in explaining why previous empirical research has found that prices show an increase after monetary tightening. We investigate how an unanticipated movement in the risk free interest rate affects all those variables responsible for the transmission of a monetary shock. Our results suggest that the immediate increase in prices is not due to some form of econometric misspecification, but rather, to the change in the composition of firms' source of finance. Prices rise because the need for external funds increases thus firms' costs of production increase. Another important issue that we want to tackle is the contribution of external finance to the 1990 economic recession. In Chapter 3 we show that the increased level of indebtedness as one of the forces at the root of the economic downturn. We argue that the crisis could be explained on the basis of Minsky's financial instability hypothesis. In the remaining part of this research we tackle the second aim of this research: we focus our attention on the link between asset prices and monetary policy. Asset prices, in fact, can give an indication of future consumers' and firms' decisions on spending and, therefore, might be indicators of future economic activity. Wealth deriving from gains in these markets tends t o increase the level of consumption and investment. A t the same time, sharp movements in asset prices could signal imbalances in the economy; developments of this kind can threaten financial stability. In Chapter 4 we argue there might be a trade-off between financial stability and monetary stability when these are the main objectives of the monetary authorities. First we explore the possibility that the demand equation is affected positively by changes in asset prices, secondly empirical findings suggest that for the period 1992: 10-2003: 1 monetary policy in the UK can be better represented by a rule which takes into consideration movements in house prices and stock prices. The empirical evidence provided in Chapter 4 brings us in Chapter 5 to construct a macroeconomic model where the asset prices enter indirectly into the Central Bank's loss function. We model the aggregate demand of the economy so that output is determined, among other variables, by the wealth effect. The optimal interest rate rule is obtained by optimising intertemporally a loss function that includes inflation and output variance. We find that the optimal policy in the presence of wealth effects not only depends upon inflation and output but also it depends on financial imbalances, as represented by asset price misalignments from fundamentals. The response to asset price deviations from fundamentals becomes more aggressive as wealth effects build up, while the reaction to inflation and the output gap becomes less pronounced

Stock Returns and Inflation: The Impact of Inflation Targeting

This paper investigates the dynamic interaction between ination and stock returns in four ination targeting countries. We find that following the introduction of formal targets, ination persistence and the magnitude of volatility spillovers between ination and stock returns have been reduced.

Unit Roots in Inflation and Aggregation Bias

In this paper, we examine whether UK inflation is characterized by aggregation bias using three sets of increasingly disaggregated inflation data and a battery of univariate and panel unit root tests. Our results support the existence of aggregation bias since while the unit root hypothesis cannot be rejected for aggregate inflation, it can be rejected for some of its sectoral components, with the rejection frequencies increasing when we use more disaggregate data. Results from structural break analysis indicate that monetary policy shifts are the main factor behind breaks in UK inflation. The panel results typically indicate that when sectoral inflation rates are pooled the unit root hypothesis can be rejected. Our results have important implications for applied econometric analysis, macroeconomic theory and for the conduct of monetary policy.Inflation, Unit Root, Disaggregation, Structural Breaks, Panel Data

Uncertainty and monetary policy

Using the minutes of decision-,making committee meetings we analyse how the Bank of England, the Czech National Bank and the Sveriges Riksbank communicate uncertainty in their discussion of the setting of a forward-looking monetary policy. The aim is to test whether information about uncertainty in the minutes helps explain interest rate settings. We find that to show the effect of uncertainty it needs to be clear what the uncertainty is about, output or inflation for example. We also show that there is a relationship between the level of uncertainty expressed and the degree of disagreement in the committees

International evidence on the new Keynesian Phillips Curve using aggregate and disaggregate data

We present a unique empirical analysis of the properties of the New Keynesian Phillips Curve using an international dataset of aggregate and disaggregate sectoral inflation. Our results from panel time-series estimation clearly indicate that sectoral heterogeneity has important consequences for aggregate inflation behaviour. Heterogeneity helps to explain the overesti- mation of inflation persistence and underestimation of the role of marginal costs in empirical investigations of the NKPC that use aggregate data. We find that combining disaggregate information with heterogeneous-consistent estimation techniques helps to reconcile, to a large extent, the NKPC with the data.New Keynesian Phillips Curve; Heterogeneity; Aggregation Bias.