One problem with the first strategy is that central banks in practice have tended to rapidly ease up on monetary policy when there is a large fall in asset prices, in order to reduce the risk of a recession. When asset prices rise, there is a tendency to wait until one is more certain this will have an effect on inflation before raising interest rates. An asymmetrical monetary policy entails a risk of indebtedness and liquidity in the economy becoming too high, when regarded over a longer time period. Sooner or later there will be an adjustment and the risk is that the imbalances will have grown so large that the cost of adjustment will be high. One can thus conclude that the consequences for the real economy of an asset price bubble can be serious. In my opinion, there is thus good reason to analyse and assess to the best of our ability to what extent asset prices are fundamentally motivated, how households’ and companies’ real demand will be affected, and where the liquidity created by bank lending goes. If the analysis shows that there is a significant risk of very negative consequences for the real economy, there may be good reason in exceptional cases to take this into account when formulating monetary policy – even if the assessments for the immediate future show that inflation will be in line with the target level. One can say that there is sometimes reason to take account of what will happen beyond the normal forecast horizon.
However, first and foremost I would like to point out that monetary policy aimed at stabilising the inflation rate should basically reduce the risk of over-valued asset prices leading to an exaggerated real demand. Fluctuations in the level of resource utilisation and in the output gap are traditionally assumed to be reflected in the inflation rate. If inflated asset prices stimulate demand in the economy, without a corresponding increase in the potential growth rate, inflation will rise. If the central bank anticipates this, monetary policy will normally be tightened to ensure that demand is compatible with long-term sustainable growth. And as long as demand in the economy increases at a rate compatible with long-term growth, there is less risk of exaggerated indebtedness. Inflation targeting should thus, at least in theory, reduce the risk of extensive financial imbalances accumulating. However, even with an otherwise successful inflation target policy, real and financial imbalances created by exaggerated asset prices can build up. If there are exaggerated expectations regarding growth in productivity and profits in a particular country, this can lead to a strong inflow of capital and strengthening of the currency. The increase in real demand, which is caused by exaggerated increases in asset prices, can thus be partly met by increased imports, while the currency strengthens and domestic inflationary pressure is reduced.