Should Central Banks Respond to Movements in Asset Prices?

Ben S. Bernanke; Mark Gertler

The American Economic Review, Vol. 91, No. 2, Papers and Proceedings of the Hundred Thirteenth Annual Meeting of the American Economic Association. (May, 2001), pp. 253-257.

Stable URL: http://links.jstor.org/sici?sici=0002-8282%28200105%2991%3A2%3C253%3ASCBRTM%3E2.0.CO%3B2-K

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http://www.jstor.org Thu Aug 23 08:39:25 2007 QUANTITATIVE POLICY IMPLICATIONS OF NEW NORMATIVE MACROECONOMIC RESEARCHt

Should Central Banks Respond to Movements in Asset Prices?

In recent decades, asset booms and busts have In use now for about a decade, inflation- been important factors in macroeconomic fluctu- targeting has generally performed well in prac- ations in both industrial and developing countries. tice. However, so far this approach has not often In light of this experience, how, if at all, should been stress-tested by large swings in asset central bankers respond to asset price volatility? prices. Our earlier research employed simula- We have addressed this issue in previous tions of a small, calibrated macroeconomic work (Berna~lkeand Gertler, 1999). The context model to examine how an inflation-targeting of our earlier study was the relatively new, but policy (defined as one in which the central increasingly popular, monetary-policy frame- bank's instrument interest rate responds primar- work known as inflation-targeting (see e.g., ily to changes in expected inflation) might fare Bernanke and Frederic Mishkin, 1997). In an in the face of a boom-and-bust cycle in asset inflation-targeting framework, publicly an- prices. We found that an aggressive inflation- nounced medium-term inflation targets provide targeting policy rule (in our simulations, one in a nominal anchor for monetary policy, while which the coefficient relating the instrument allowing the central bank some flexibility to interest rate to expected inflation is 2.0) sub- help stabilize the real economy in the short run. stantially stabilizes both output and inflation in The inflation-targeting approach gives a specific scenarios in which a bubble in stock prices answer to the question of how central bankers develops and then collapses, as well as in sce- should respond to asset prices: Changes in asset narios in which technology shocks drive stock prices should affect monetary policy only to the prices. Intuitively, inflation-targeting central extent that they affect the central bank's fore- banks automatically accommodate productivity cast of inflation. To a first approximation, once gains that lift stock prices, while offsetting the predictive content of asset prices for infla- purely speculative increases or decreases in tion has been accounted for. there should be no stock values whose primary effects are through additional response of monetary policy to asset- aggregate demand. price fluctuations.' Conditional on a strong policy response to expected inflation, we found little if any ad- ditional gains from allowing an independent response of central-bank policy to the level of + Disclrsscu~ts: Robert Shiller, Yale University; Glenn Rudebusch, Federal Reserve Bank of San Francisco; Ken- asset prices. In our view, there are good rea- neth Rogoff, Harvard University. sons, outside of our formal model, to worry 'Woodrow Wilson School, Princeton University, about attempts by central banks to influence Princeton, NJ 08544 (e-mail: bernankeOprinceton.edu), asset prices, including the fact that (as history and Depaltment of Economics, New York University, 267 has shown) the effects of such attempts on Mercer St., 7th floor, New York, NY 10003 (e-mail: market psychology are dangerously unpre- mark.gertlerOecon.nyu.edu), respectively. We thank Fabio Natalucci and Michele Cavallo for excellent research assis- dictable. Hence, we concluded that inflation- tance, and Simon Gilchrist for helpful comments. targeting central banks need not respond to ' As discussed in what follows, an additional response is asset prices, except insofar as they affect the warranted in theory if changes in asset prices affect the inflation forecast. natural real rate of interest, though we find this effect to be quantitatively small in our simulations. Also, this prescrip- In the spirit of recent work on robust control, tion is not intended to rule out short-term interventions to the exercises in our earlier paper analyzed the protect financial stability. performance of policy rules in worst-case 253 254 AEA PAPERS AND PROCEEDINGS MAY 2001

scenarios, rather than on average. However, the a given innovation on stock prices persists into more conventional approach to policy evalua- the subsequent period with fixed probability, set tion is to assess the expected loss for alternative equal to one-half in our simulations. If an inno- policy rules with respect to the entire probabil- vation persists, it grows at a rate equal to a fixed ity distribution of economic shocks, not just the parameter a times the fundamental rate of return most unfavorable outcomes. That is the ap- on capital, divided by the probability of contin- proach taken in the present article. We conduct uation. If the parameter a were to equal 1.O, the stochastic simulations of the same model we non-fundamental component would be a ratio- used earlier to evaluate the expected performance nal bubble, in the sense of Olivier Blanchard of alternative policy rules. We consider stock- and Mark Watson (1982). To preserve long-run price "bubble" shocks, technology shocks, and stationarity, we choose instead a = 0.99, so the two in combination. Although the policy- that the non-fundamental component has a evaluation approach is different from our previous weak mean-reverting tendency. Agents are as- work, the results of these simulations are comple- sumed to know the statistical ~rocessthat drives mentary to what we found earlier. We find again bubbles, though they do not know in advance that an aggressive inflation-targeting rule stabi- their ultimate magnitude or duration. The pri- lizes output and inflation when asset prices are mary effect of a bubble is to increase aggregate volatile, whether the volatility is due to bubbles or demand, by increasing consumers' wealth and to technological shocks; and that, given an aggres- by improving the balance sheets of borrowers. sive response to inflation, there is no significant The model is calibrated as in Bernanke and additional benefit to responding to asset prices. Gertler (1999), except that here we have in- creased the elasticity-of Tobin's q with respect I. The Model and the Simulation Method to investment from 0.5 to 2.0, as is consistent with the evidence. In addition, to introduce The model we use is essentially the same as more realistic persistence in the response of in Bernanke and Gertler (1999), which in turn Tobin's q to productivity shocks, we introduce was an extension of the framework developed in diminishing returns into the production of new Bernanke et al. (2000). Broadly, the model is a capital goods, though this modification does not standard dynamic new-Keynesian model, aug- materiallv affect the results. mented in two ways. First, it incorporates an We considered simulations of the model, un- informational friction in credit markets, by der alternative monetary-policy rules, for (i) means of the assumption that monitoring of random draws of the bubble process, (ii) ran- borrowers by lenders is costly. This credit- dom draws of the technology shock, and (iii) market friction gives the model a "financial combinations of shocks to the bubble and to accelerator," a mechanism by which endoge- technology. As described earlier, the duration nous changes in borrowers' balance sheets en- and hence the maximum size of each bubble are hance the effects of exogenous shocks. For stochastic. Because our linear approximation example, in our model a boom in stock prices becomes less accurate as the bubble becomes raises output not only via conventional wealth veiy large, we assume that bubbles that have and Tobin's q effects, but also by increasing the lasted five periods collapse with certainty in the net worth of potential borrowers. As borrowers sixth period. ~e~endingonthe monetary-policy become wealthier and thus more able to self- rule, a positive one-standard-deviation initial finance, the expected deadweight losses of ex- bubble shock that lasts the full five periods can ternal finance decline, further increasing cause stock prices to rise 25-30 percent above investment and output. their steady-state values. Experiments con- The second modification, introduced in Ber- firmed that our qualitative results are not af- nanke and Gertler (1999), is to allow an addi- fected by allowing the bubble to run for a tive, non-fundamental component in stock maximum of seven periods (the unconditional prices. We model this non-fundamental compo- probability of a bubble lasting more than seven nent as an exogenous stochastic process. Inno- periods is less than 1 percent). Technology vations to this process are drawn randomly each shocks are modeled as permanent shifts in total period from a normal distribution. The effect of factor productivity (TFP). The standard devia- VOL. 91 NO. 2 POLICY IMPLICATIONS OF MACROECONOMIC RESEARCH 255

TABLE2-TECHNOLOGYSHOCKSONLY

Policy rule Policy rule

(vTT, S, Y) (vTT, S, Y) uy 0.7, 1.01, 0, 0 1.01, 0, 0 0.73 6.23 1.01, 0.05, 0 1.01, 0.05, 0 0.18 25.06 1.01, 0.1, 0 1.01, 0.1, 0 0.48 42.24 1.01, 0, 0.5 1.01, 0, 0.5 0.28 2.79 2, 0, 0 2, 0, 0 0.24 0.14 2, 0.05, 0 2, 0.05, 0 0.22 0.28 2, 0.1, 0 2, 0.1, 0 0.19 0.62 2, 0, 0.5 2, 0, 0.5 0.22 0.05 3, 0, 1 3, 0, 1 0.21 0.05

TABLE3-BUBBLE AND TECHNOLOGYSHOCKS tion of innovations to TFP is assumed to be 1 percent of its initial level. Policy rule As for policy rules, we considered simple (T, S, Y) rules relating the central bank's nominal interest rate to next period's expected inflation, the cur- rent level of the stock market, and the output gap (defined as actual output less output under flexible prices and with no credit frictions). The response of the interest rate to expected inflation was varied between 1.01 and 3, the response to log stock prices between 0 and 0.2, and the response td the output gap between 0 and 2. For each choice of rule parameters, we calculated the unconditional variances of the output gap results for simulations in which both bubble and inflation, as well as the overall loss, as shocks and technology shocks are drawn in each measured by various quadratic loss functions in period. For the last case, we assumed that the the output gap and inflation. correlation of bubble shocks and technology shocks is 0.9, to capture the idea that bubbles 11. Simulation Results may be more likely to develop when fundamen- tals are also strong. However, the results were Representative simulation results are shown similar when this correlation was set to other in the tables. For each table, in the first cell of values, including zero. each row, the triple of numbers indicates the The clearest conclusion to be drawn from policy rule being evaluated. The first number of Tables 1-3 is that "aggressive" inflation- the triple is the response of the nominal interest targeting rules, in which the response of the rate to expected inflation (T),the second num- nominal interest rate to expected inflation is 2 ber is the response of the interest rate to the log or 3, strongly dominate "accommodative" of the price of capital, or Tobin's q (s), and the rules, in which the response to expected in- third number is the response of the interest rate flation is 1.01 (a value that barely satisfies the to the output gap (y). The second and third stability condition that real interest rates rise columns show the unconditional variances of when expected inflation rises). The superior- the output gap, a,, and inflation, a,, both in ity of aggressive inflation-targeting holds for percentage points. With no discounting, qua- both types of shocks and their combination. dratic losses for each policy can be calculated The reduction in inflation variability from directly as linear combinations of these vari- aggressive inflation-targeting is particularly ances. Table 1 shows results for the case of striking, as might be expected, but in nearly bubble shocks only, Table 2 covers the case of all cases variability of the output gap is also technology shocks only, and Table 3 reports reduced. 256 AEA PAPERS AND PROCEEDINGS MAY 2001

Our simulations suggest that good policy rules the case of technology shocks (Table 2), the will react sensitively to expected inflation, but policy (2, 0.1, 0) is to be prefei~edto (2, 0, 0) consistent with the widely held view that inflation- only if the loss-function weight on output-gap targeting should be applied "flexibly," they show variability exceeds 0.9, and to the policy (3, 0, that policy should respond to the output gap as 1) only if the weight on output-gap variability well. Indeed, with equal weighting of the output exceeds 0.96. Similar results obtain for the other gap and inflation in the loss function, we find that scenarios. We conclude that for plausible pa- the policy (3, 0, 1) performs best across the dif- rameter values the central bank should not re- ferent scenarios (conditional on a relatively coarse spond to asset prices. grid search). Notice that this policy involves zero weight on stock prices. 111. Relation to the Literature Although the optimal policy (for equal weighting of output and inflation) never in- There has been considerable debate on the volves a response to stock prices, we can see appropriate role of asset prices in the formula- from Tables 1-3 that adding a stock-price re- tion of monetary policy. Recent contributions sponse to a rule that targets only inflation typi- include Charles Goodhart (2000), Nicoletta Ba- cally leads to a small reduction in variability of tini and Edward Nelson (2000), and Andrew J. the output gap. Compare, for example, the pol- Filardo (2000). The paper most closely related icies (2, 0, o), (2,0.05, o), and (2,0.1,0) in each to our work, however, is by Stephen Cecchetti of Tables 1-3. Our interpretation of this effect is et al. (2000). Indeed, a portion of their paper as follows: A shock to stock prices (either employs simulations of the model of Bernanke from a bubble or from technology) may tem- and Gertler (1999), the same model used in this porarily change the natural realrate of inter- paper. Contrary to our findings, however, Cec- est, a change that in principle should be chetti et al. claim to find strong support for accommodated by a fully optimal policy rule. including stock prices in the central bank's pol- Putting a small weight on stock prices there- icy rule. What accounts for this striking differ- fore may help a bit, at least in some circum- ence in conclusions? stances and on some dimensions. In computing their prefened policy rules, However, shocks to stock prices are not unique Cecchetti et al. do not take into account either in this regard; by the same logic, monetary policy the probabilistic nature of the bubble or the should respond to any shock that changes the possibility that shocks other than a bubble may natural real rate of interest; there is no theoretical be driving asset prices. Specifically, Cecchetti justification for singling out the stock market. In- et al. "optimize" the policy rule with respect to deed, as noted, the simulations show that allowing a single scenario, a bubble shock lasting pre- the policy rule to respond to the output gap elim- cisely five periods, rather than with respect to inates any benefits of responding to stock prices. the entire probability distribution of shocks, in- Admittedly, the output gap is difficult to measure, cluding shocks other than bubble shocks. Effec- but we are more confident in economists' ability tively, their procedure yields a truly optimal to measure the output gap than to measure the policy only if the central bank (i) knows with fundamental component of stock prices; the per- certainty that the stock-market boom is driven centage standard deviation of estimates of stock- by non-fundamentals and (ii) knows exactly price fundamentals surely far exceeds that of when the bubble will burst, both highly unlikely potential output. In addition, the behavior of in- condition^.^ In contrast, we find (Table 1) that, flation provides a real-time indicator of the mag- nitude of the output gap, whereas there is no analogous indicator to provide confirmation of Even so, under reasonable parametrizations, our ag- estimates of stock fundamentals. gressive inflation-targeting rule performs nearly as well as In any case, our simulations show that the the optimal policy based on these extraordinary information small benefits in terms of reduced output-gap assumptions. It appears otherwise in Cecchetti et al. (2000) because they report the loss under our rule divided by the variability of responding to stock are loss under their optimal rule, where the latter is a number likely to be outweighed by the associated in- close to zero. However, by any reasonable metric, the nb- crease in inflation variability. For example, in solute difference in losses is very small. VOL. 91 NO. 2 POLICY IMPLICATIONS OF MACROECONOMIC RESEARCH 257

even if the central bank is certain that a bubble Bernanke, Ben and Gertler, Mark. "Monetary is driving the market, once policy performance Policy and Asset Volatility." Federal Reserve is averaged over all possible realizations of the Bank of Kansas City Economic Review, bubble process, by any reasonable metric there Fourth Quarter 1999, 84(4), pp. 17-52. is no consequential advantage of responding to Bernanke, Ben; Gertler, Mark and Gilchrist, Si- stock prices. Moreover, a too-aggressive re- mon. "The Financial Accelerator in a Quan- sponse to stock prices can create significant titative Business Cycle Framework," in harm in that ~cenario.~Batini and Nelson J. Taylor and M. Woodford, eds., Handbook (2000) find an analogous result for bubbles in of macroeconomics. Amsterdam: North- the real exchange rate. Holland, 2000, pp. 1341-93. A deficiency of the literature to date is that Bernanke, Ben and Mishkin, Frederic. "Inflation the nonfundamental component of stock prices Targeting: A New Framework for Monetary has generally been treated as exogenous. Our Policy?" Journal of Economic Perspectives, own view is that the macroeconomic stability Spring 1997, 11(2), pp. 97-116. associated with inflation-targeting is likely to Blanchard, Oliver and Watson, Mark. "Bubbles, reduce the incidence of panic-driven financial Rational Expectations, and Financial Mar- distress that could destabilize the economy, kets," in P. Wachtel, ed., Crisis in the but this question is clearly deserving of fur- economic and financial structure. Lex- ther research. ington, MA: Lexington Books, 1982, pp. 295-316. REFERENCES Cecchetti, Stephen; Genberg, Hans; Lipsky, John and Wadhwani, Sushi]. Asset prices and cen- Batini, Nicoletta and Nelson, Edward. "When the tral bank policy. London: International Bubble Bursts: Monetary Policy Rules and Center for Monetary and Banking Studies, Foreign Exchange Market Behavior." Work- 2000. ing paper, Bank of England, 2000. Filardo, Andrew J. "Monetary Policy and Asset Prices." Federal Reserve Bank of Kansas City Economic Review, Third Quarter 2000, 'In results not reported here, we find that the ham1 from 85(3), pp. 11-37. targeting stock prices can rise significantly if the non- fundamental component of stock prices affects spending Goodhart, Charles. "Asset Prices and the Con- less than does the fundamental component, as seems con- duct of Monetary Policy." Working paper, sistent with the evidence. London School of Economics, 2000. http://www.jstor.org

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Inflation Targeting: A New Framework for Monetary Policy? Ben S. Bernanke; Frederic S. Mishkin The Journal of Economic Perspectives, Vol. 11, No. 2. (Spring, 1997), pp. 97-116. Stable URL: http://links.jstor.org/sici?sici=0895-3309%28199721%2911%3A2%3C97%3AITANFF%3E2.0.CO%3B2-E