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Asset prices and monetary policy.

Article Excerpt
Crisis: Time to Ponder on Traditional Wisdom

Beyond dealing with the immediate problems, any crisis raises questions of why and how we got there and what lessons should be drawn to avoid a repetition of past developments--without laying the ground for a new disaster. This line of inquiry also applies to the current crisis in financial markets. Even during the heaviest turbulence a discussion has started on obvious deficits in the system of regulation and supervision and on badly needed improvements. In this article, I concentrate on monetary policy but that does not mean regulatory measures are irrelevant in this context, quite the opposite.

For central banks the relation between monetary policy and asset prices has gained new interest and the dominant view has come under critique.

The Consensus View

There is a broad consensus around the world that central banks should maintain price stability--keeping inflation low and stable. This objective is reflected in the mandate given to the central banks in many countries. Price stability is normally specified in terms of stabilizing an index of consumer prices in one form or another. There are very good reasons for this practice. The purchasing power of money is undermined by an increase in consumer prices; a constant index of consumer prices maintains the real value of money over time. With stable prices, money serves society best as a unit of account, medium of exchange, and store of value.

Any index of consumer prices covers only a segment of prices in an economy--although an important one. Prices of assets like real estate or equities are excluded by definition. Most of the time this omission is not seen as a problem, quite the opposite. Monetary policy can only control the development of goods prices over the medium to long term. But, in times of large movements of assets prices, the debate always starts on whether this concentration of monetary policy on consumer prices alone is appropriate or not.

Asset price developments have an influence on spending decisions by companies and households. A rising value of one's house makes people richer and might encourage additional consumption. Higher stock prices reduce the cost of equity financing and might help increase...

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