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Asset Prices in a Flexible Inflation Targeting Framework

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  • Stephen G. Cecchetti
  • Hans Genberg
  • Sushil Wadhwani

Abstract

We argue that there are sound theoretical reasons for believing that an inflation targeting central bank might improve macroeconomic performance by reacting to asset price misalignments over and above the deviation of, say, a two-year ahead inflation forecast from target. In this paper, we first summarize the arguments for our basic proposition. We then discuss some of the counter-arguments. Specifically, we counter those who argue that reacting to asset prices does not improve macroeconomic performance by claiming that they are attacking the 'straw man' under which central bankers react in the same way to all asset price changes. We continue to emphasize that policy reactions to asset price misalignments must be qualitatively different from reactions to asset prices changes driven by fundamentals. Hence, we stand by our earlier results and conclusions. In practice, we do believe that central bankers can detect large misalignments (e.g. the Nikkei in 1989 or the NASDAQ in early 2000), and that they might be in a better position to react to long-lived bubbles than many market participants. However, we recognize that our proposal may present communication challenges, and it is critically important that policy set to react to asset price misalignments both be explained well and that it be based on a broad consensus. It is also important to emphasize that our proposal is wholly consistent with the remit of most inflation-targeting central banks, as we are recommending that while they might react to asset price misalignments, they must not target them.

Suggested Citation

  • Stephen G. Cecchetti & Hans Genberg & Sushil Wadhwani, 2002. "Asset Prices in a Flexible Inflation Targeting Framework," NBER Working Papers 8970, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:8970
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    References listed on IDEAS

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    1. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
    2. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters,in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
    3. Jorion, Philippe & Mishkin, Frederic, 1991. "A multicountry comparison of term-structure forecasts at long horizons," Journal of Financial Economics, Elsevier, vol. 29(1), pages 59-80, March.
    4. Stephen G. Cecchetti & Rita S. Chu & Charles Steindel, 2000. "The unreliability of inflation indicators," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 6(Apr).
    5. William Poole, 1969. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Special Studies Papers 2, Board of Governors of the Federal Reserve System (U.S.).
    6. Ben S. Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
    7. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
    8. Gerlach, Stefan, 1997. "The Information Content of the Term Structure: Evidence for Germany," Empirical Economics, Springer, vol. 22(2), pages 161-179.
    9. Frederic S. Mishkin, 2001. "The Transmission Mechanism and the Role of Asset Prices in Monetary Policy," NBER Working Papers 8617, National Bureau of Economic Research, Inc.
    10. William Poole, 1970. "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," The Quarterly Journal of Economics, Oxford University Press, vol. 84(2), pages 197-216.
    11. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
    12. Batini, Nicoletta & Nelson, Edward, 2000. "When the Bubble Bursts: Monetary Policy Rules and Foreign Exchange Market Behavior," Working Papers 2000-01, University of Sydney, School of Economics.
    13. Allen, Franklin & Gale, Douglas, 2000. "Bubbles and Crises," Economic Journal, Royal Economic Society, vol. 110(460), pages 236-255, January.
    14. Goodhart, Charles & Hofmann, Boris, 2000. "Do Asset Prices Help to Predict Consumer Price Inflation?," Manchester School, University of Manchester, vol. 68(0), pages 122-140, Supplemen.
    15. Christopher Kent & Philip Lowe, 1997. "Asset-price Bubbles and Monetary Policy," RBA Research Discussion Papers rdp9709, Reserve Bank of Australia.
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    More about this item

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G0 - Financial Economics - - General

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