Impact of asset prices on monetary policy in an inflation targeting regime

Abstract

The global inflation through the course of the 90s has been predominantly underpinned by moderating inflation and lower general price levels. Central bankers1 argue that this is a new precedent in macroeconomic history, wherein, unlike the previous oil shocks of 1973-74, 79-80 or 89-90, where the inflationary impact was immediate and pronounced. This also comes out as being a different in light of the appreciation of the dollar against Asian currencies, and yet not being clearly reflected in price levels. Starkly different is that fact that there has been low customer inflation in the face of abundant liquidity. Besides, there has been strong global growth despite a decrease in the household saving. While it might be argues that globalization, deregulation and enhanced productivity (out of technological improvements, IT infrastructure etc) have contained inflation, this can also possibly arise from the fact that several central banks have taken to inflation targeting in the 90s. Higher liquidity has also led to debt financed consumption and investment. This, coupled with low bond yields and flat yield curves in the last few years, there has been a compression of credit risk spreads. This is suspected to have increased the risks embedded in the financial system and worries in the face of a global correction in world markets. Yet, a fundamental issue still remains as to why fluctuations in asset prices should be a cause for concern2. In a market economy the prices of both financial assets and goods and services have the role of providing information; fluctuations in share and real asset prices are useful as long as they reflect changes in expectations regarding the future course of the economy. The price of an asset is the discounted value of future cash flows expected from it. Hence an increase in asset prices construes an anticipation of an increase in lifetime income. Investors expect a real rate of return over the lifetime of the asset and hence, given the current price, and constancy in this anticipated return, once can trace investor expectations of expected inflation, In addition, inflated asset prices make the cost of new investment lower, when compared to the economic opportunity cost of existing assets. However, history shows that investors are often over-optimistic in framing expectations and that share prices rise more than is later proved to be motivated by fundamentals. Rapidly rising asset prices do not constitute a problem in themselves that requires corrective measures. Deciding factors here are whether there is reason to regard asset prices as fundamentally exaggerated and whether the bubble has led to excessive demand in the real economy, as well as misallocation of resources and excessive indebtedness. If households increase their consumption as a result of exaggerated increases in the value of shares and property, it could lead to the build-up of large real and financial imbalances. Companies can increase their investments as a result of lower financing costs on a risk capital market with over-valued share prices, but also because a rise in the value of the companies' assets increases their credit ratings. At the same time, financing consumption, investment, property and financial assets through loans will lead to an excessive credit boom. The liquidity created when the banks increase their lending can further push up asset prices. When the bubble bursts and asset prices fall, it could lead to heavily indebted households and companies and to a fall in consumption and investment. A decline in demand would reduce companies’ profits and increase the number of bankruptcies. Bankruptcies lead to losses in the banks, while the value of the assets taken as collateral for loans would decline. A deterioration in bank profits can reduce the supply of loans and mean that investments that would have been profitable do not get off the ground. In the worst possible scenario, systemically-important banks would suffer a bank crisis. Falling asset prices thus risk triggering processes that could eventually lead to a recession.

A shock in asset prices would hence lower the amount of banking collateral and cause financial institutions to tighten interest rates, resulting in a slowdown in output growth. The extent and speed of transmission of a shock in asset prices would depend on the level of financial integration in the system, where imbalances in one market can be transferred to another. In addition, asset prices are susceptible to shifts in investor sentiment, exogenous of a justifying change in fundamentals. The occurrence of large asset price fluctuations in the late 1980s and early 1990s raised a good deal of discussion among economic researchers and policymakers regarding whether and how central banks should respond to asset price fluctuations3. Bernanke and Gertler (BIS Working Paper 1998) conclude that central banks should take into account asset price movements only as far as these fluctuations have an impact on expected future inflation and output.