The challenge for central banks is to determine how movements in asset values and expected asset values affect the evolution of the economy. There is little to suggest that the task has gotten easier with the increasing complexity of financial markets, and it has more likely gotten harder. The incorporation of asset price movements into monetary policy formation is hard to do, in part, because we don’t know that much about the transmission mechanism from movements in asset values to the underlying economic fundamentals we care about. We cannot estimate with a high degree of confidence the effects of realized asset price movements on economic outcomes. The relationship, for example, between changes in housing prices or equity prices and household savings and consumption varies substantially across time and circumstances, a fact that only exacerbates the difficulty of sorting out the effect of changes in wealth from other factors, such as greater confidence in future real growth resulting from the acceleration in productivity growth. And successfully integrating asset prices into monetary policy formulation is also hard to do because of the difficulty of assessing how potential alternative paths for monetary policy will feed through to overall financial conditions and thereby for output and inflation—in other words it is difficult to forecast how changes in current or expected policy will affect asset values. These and other factors magnify the challenge of taking asset prices into account in the formulation of monetary policy.
In other words, central banks have to be prepared to adjust policy when past asset price increases could be a significant factor putting upward pressure on aggregate demand, as well as when past declines threaten to reduce output relative to potential. Although the potential case for adjusting policy applies in both directions, the implications for policy may differ. Because some asset prices may fall more abruptly than they rise, and because the effects of downward moves in asset prices on demand may be larger due to the greater negative impact of deflation on the net worth of borrowers—witness the United States in the 1930s or Japan in the 1990s, the case for adjusting monetary policy in response to negative asset price shocks is commonly considered more compelling than in the alternative context. But this does not mean that monetary policy should generally ignore the effects of increases and only respond to observed declines in asset prices. The test should be the size and circumstances of the asset price moves and their impact on the forecast relative to the central banks’ objectives, not the direction of the asset price move. Different considerations apply in the circumstances where the central bank is considering how a potential future move in asset prices may affect the forecast. These circumstances call for even greater caution and care.