The housing market crisis is the latest reminder that asset prices can and do run wild at rates capable of negative effects on real economic activity. Not surprisingly, this has reinvigorated debate over whether central banks should respond to asset price bubbles.Monetary policy ; Asset pricing

Brett W. Fawley

Luciana Juvenal

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2010 ■ Number 11
T
he housing market crisis is the latest reminder that
asset prices can and do run wild at rates capable of
negative effects on real economic activity. Not sur-
prisingly, this has reinvigorated debate over whether central
banks should respond to asset price bubbles. Economists’
views on this subject are divided. Some argue that the central
bank should react to asset price misalignments (see, for
example, Cecchetti, Genberg, and Wadhwani, 2002). Those
opposed to this idea say that monetary policy focused
exclusively on stable inflation achieves better long-run
outcomes (see Bernanke and Gertler, 2001).
The volatility and unpredictability of asset prices are
well-known problems. As Mishkin (2007) notes, however,
there are assumptions under which monetary policy could
be effective in responding to asset price bubbles. First, the
central bank must be able to identify that a bubble truly
exists, which is a strong assumption since no rule exists to
assess the presence of a bubble. Hindsight is 20/20, and
some episodes that at first look like bubbles in retrospect
are not.
Second, the central bank must
apply the right policy to deflate the
bubble. This is not as straightforward
as it seems. Bubbles are episodes in
which people do not behave in a
predictable way. Thus, predicting
the consequences of an interest rate
increase is difficult. The question is
whether no action is better than the
wrong action. For example, a central
bank response that increases interest
rates but results in a recession when
no bubble was present is clearly not
desirable.
Selecting the correct policy
response is further complicated by
the difficulty in identifying a clear
pattern between monetary policy
and asset prices across countries.
The chart uses deviations from the
Taylor rule to plot the relationship among real house prices,
real stock prices, and the monetary stance for 20 industrial-
ized countries.1 Countries on the upper half of the figure
had larger increases in asset prices than the rest of the sam-
ple during the recent bubble. Countries on the left-most
side practiced looser monetary policies with respect to the
Taylor rule. Interestingly, more than half of the countries
implemented tighter monetary policy but had higher hous-
ing price increases than the United States (these are plotted
Monetary Policy and Asset Prices
Brett Fawley, Research Analyst
Luciana Juvenal, Economist
The housing market crisis is the latest
reminder that asset prices can and do
run wild at rates capable of negative
effects on real economic activity. 
Not surprisingly, this has reinvigorated
debate over whether central banks
should respond to asset price bubbles.
Taylor Rule Residuals Plotted Against Change in Real House Prices and 
Change in Real Stock Prices 
AUT
BEL CHE
DEN
DEU
ESP FIN FRA
GBR
GRC
IRL ITA
NOR
NLD
SWE
USA
AUS
CAN JPN NZL
AUT
BEL
CHE
DEN
DEU
ESP
FIN
FRA GBR
GRC
IRL
ITA
NOR
NLD
SWE
USA
AUS CAN
JPN
NZL
–4.5 –4 –3.5 –3 –2.5 –2 –1.5 –1 –0.5 0 0.5 1
–90
–70
–50
–30
–10
10
30
50
70
Average Taylor Rule Residuals   
Percent Change in Real House Prices
(2001:Q4–2006:Q3)
Percent Change in Real Stock Prices
(2003:Q1–2007:Q3)
NOTE: Changes in house prices are plotted against the average Taylor rule residual between 2002:Q1 and 2006:Q3 
and appear as black squares; changes in stock prices are plotted against the average Taylor rule residual between 
2003:Q2 and 2007:Q3 and appear as blue circles. AUS, Australia; AUT, Austria; BEL, Belgium; CAN, Canada; CHE, 
Switzerland; DEN, Denmark; DEU, Germany; ESP, Spain; GBR, United Kingdom; GRC, Greece; FIN, Finland; FRA, France; 
IRL, Ireland; ITA, Italy; JPN, Japan; NLD, Netherlands; NOR, Norway; NZL, New Zealand;  SWE, Sweden; USA, United States.
SOURCE: International Monetary Fund. World Economic Outlook: Crisis and Recovery, April 2009.
50
100
150
200
250
300
350
400above and to the right of the United States). Most countries
practiced tighter monetary policy and saw higher stock
price increases than the United States.
The solid black trend line suggests that looser monetary
policy is associated with higher housing prices, but this
relationship is weak. The pattern is less clear for stock prices
(dashed blue line). This suggests that even if the central
bank could identify a bubble and apply the best policy, it
might not be able to deflate the bubble if the link between
interest rates and asset prices is weak. ■
Bernanke, Ben S. and Gertler, Mark. “Should Central Banks Respond to Movements
in Asset Prices?” American Economic Review, May 2001, 91(2), pp. 253-57.
Cecchetti, Stephen, G.; Genberg, Hans and Wadhwani, Sushil. “Asset Prices in a
Flexible Inflation Targeting Framework.” NBER Working Paper 8970, National
Bureau of Economic Research, June 2002;
www.nber.org/papers/w8970.pdf?new_window=1.
Mishkin, Frederic S. “Housing and the Monetary Transmission Mechanism.”
Presented at a symposium sponsored by the Federal Reserve Bank of Kansas
City, “Housing, Housing Finance, and Monetary Policy,” Jackson Hole, Wyoming,
August 30-September 1, 2007;
www.kansascityfed.org/Publicat/Sympos/2007/PDF/Mishkin_0415.pdf.
1 The Taylor rule says that if gross domestic product (GDP) is in line with the
economy’s potential output and inflation is equal to the central bank’s target, then
interest rates will be at a neutral level and the economy will neither accelerate nor
decelerate. If GDP grows above the economy’s potential output, or if inflation is
higher than the central bank target, then interest rates will be above the neutral
level. The effect of below-capacity GDP or below-target inflation is symmetric
but opposite. 
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on April 28, 2010
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Monetary policy and asset prices

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