June 15, 2001
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Asset Prices, Exchange Rates, and Monetary Policy
Glenn D. Rudebusch
This Economic Letter summarizes the papers presented at the conference “Asset Prices, Exchange Rates, and Monetary Policy” held at Stanford University on March 2-3, 2001, under the joint sponsorship of the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research.
During the past decade, asset markets have played an increasingly important role in many economies, and fluctuations in asset prices have become an increasingly important factor for policymakers. Indeed, movements in exchange rates, equity values, and prices for real assets such as housing and real estate, have each been, at various times, the focus of keen interest at central banks. In a variety of situations, central banks have questioned how they should respond to fluctuations in asset prices.
The six papers presented at this conference provide some first steps in understanding what central banks can and should do with regard to asset prices. The papers are listed at the end and are available at http://www.federalreservebanksf.org/economic-research/events/2001/march/asset-prices-exchange-rates-and-monetary-policy-conference/.
The papers by Stock and Watson and by Goodhart and Hofmann provide analyses of the forecasting ability of asset prices for inflation and output. As a whole, their conclusions are cautionary, even skeptical, regarding the ability of individual asset prices to consistently forecast well. However, both papers are more optimistic about the ability of combinations of asset prices—composite financial indexes or weighted averages—to produce useful forecasts.
The papers by Leitemo and Söderström and by Batini, Harrison, and Millard contribute to the rapidly growing monetary policy rules literature (e.g., Taylor 1999). Both papers consider the appropriate response of central banks to movements in foreign exchange rates. The first paper examines the success of monetary policy rules when there is uncertainty about what determines exchange rates and provides an important contribution to the literature on robust monetary policy rules. The second paper focuses on whether the exchange rate adds information to a policy rule that responds to inflation forecasts. Both papers suggest a fairly limited policy reaction to exchange rate movements.
The paper by Gertler, Gilchrist, and Natalucci explores the interaction between financial distress—weakening asset prices and tightening financial conditions—and the exchange rate regime. Under fixed exchange rates, this paper shows that the central bank has great difficulty in adjusting interest rates to alleviate the financial distress and stabilize the economy.
Finally, the paper by McCallum considers whether the liquidity trap, in which nominal interest rates have been lowered to their absolute minimum of zero, is a problem of practical importance. The paper emphasizes that even with the interest rate policy instrument immobilized by a liquidity trap, an exchange rate channel may still be available to the central bank to stabilize the economy.
The Stock and Watson paper assesses the ability of asset prices to predict inflation and output using both in-sample and simulated out-of-sample techniques. To set the stage for this analysis, the authors first provide a survey of 66 previous papers on this subject. Much of this previous research is contradictory, with an initial series of papers identifying a potent predictive relation, which is subsequently found to break down in the same country or not to be present in other countries. Based on this literature review, Stock and Watson argue that many of the purported empirical forecasting relationships are ephemeral. However, the most robust and convincing evidence indicates that the spread between long-term and short-term interest rates usually predicts real economic activity.
The authors go on to conduct their own econometric analysis of the practical value of asset prices as predictors of real economic activity and inflation. Their empirical results are consistent with their review of the literature: Certain individual asset prices have predictive content for output growth in some countries during certain periods. The uncertainty and instability of these informational relationships make it unlikely that they can be exploited. Furthermore, the evidence is even weaker that asset prices can forecast inflation. An exception to these pessimistic results is that Stock and Watson find that combining information from a large number of asset prices does seem to result in reliable forecast accuracy improvements. They argue that this is a promising avenue for future research.
Goodhart and Hofmann also examine the amount of information in asset prices for forecasting future economic activity and inflation. These authors, however, focus on creating a “Financial Conditions Index” (FCI) that provides a broad measure of the relative tightness or looseness of financial factors in restraining or promoting economic expansion. As a predecessor, a “Monetary Conditions Index” (MCI) has been constructed by some central banks as a weighted average of a short-term policy interest rate and the foreign exchange rate. Such MCIs have been used as summary measures of the stance of monetary policy because both higher interest rates and higher exchange rates reduce real demand and affect the prospects for future inflation.
Goodhart and Hofmann consider whether an MCI could be usefully broadened to an FCI that also includes the real prices of housing and equities. These additional asset prices are thought to be important determinants of the wealth effect on consumption and so might provide useful information on future aggregate demand. The authors construct FCIs for each of the G7 economies, with component weights chosen to maximize the performance of the indexes in explaining the output gap. This analysis is done with both a small structural model and a nonstructural model. The resulting indexes are then evaluated on how well they predict inflation. The authors find that while the indexes tend to lead inflation, they did not clearly out-perform a simple alternative model in an out-of-sample inflation forecasting exercise.
The Leitemo and Söderström paper examines whether a more stable economy can be achieved when the central bank relies on the exchange rate in setting monetary policy. In an open economy, movements in the exchange rate have several important effects. First, an increase in the real exchange rate boosts the demand for domestic goods as foreign goods become relatively more expensive. Second, the more expensive foreign goods increase consumer prices directly and raise firms’ costs through imported intermediate goods. Therefore, it seems possible that the exchange rate could serve as a useful indicator of policy. (This reasoning also underlies some of the popularity of the MCIs described above.)
Unfortunately, movements in the exchange rate are not very well understood in practice. In particular, the main theories of exchange rate determination—namely, the parity conditions that link prices of tradeable goods and interest rates across countries—do not have much empirical support. Thus, there is a high degree of uncertainty about how exchange rates will react to changes in monetary policy or other economic factors.
This paper allows for exchange rate uncertainty by considering four different models of exchange rate determination. The paper examines how a policy rule developed assuming one exchange rate process performs in stabilizing the economy when exchange rates are actually set by another process. The authors find that policy rules that include the exchange rate are less robust to this form of model uncertainty than other rules. In particular, a Taylor rule, which includes a response to the output gap and inflation, stabilizes the economy, in general, better than a Taylor rule augmented with the exchange rate. (See Dennis 2001 for further discussion.)
The Batini, Harrison, and Millard paper also examines the properties of various optimal simple rules in an open economy model. Their model is richer than most in the literature as it contains both a tradeable and a non-tradeable good. The presence of these two sectors generates asymmetric effects because the traded good is more sensitive to exchange rate movements than the non-traded good. The analysis also considers a larger set of possible monetary policy rules than most research. Among the rules analyzed are some developed for closed economies and some open-economy rules with an explicit exchange rate response. The authors favor a rule in which the interest rate is set in response to deviations of expected future inflation from an inflation target. These “inflation-forecast-based” rules perform quite well in their model. Adding a separate exchange rate response to this rule provides only a marginal improvement in performance.
The Gertler, Gilchrist, and Natalucci paper examines the effect of a “financial accelerator” in a small open economy. The financial accelerator links the condition of a borrower’s balance sheet to the cost of borrowing and hence to the demand for capital. In essence, entrepreneurs borrowing from a bank pay a risk premium that varies inversely with their net worth, so the cost of finance increases as the entrepreneur becomes more leveraged. In the aggregate, a drop in asset prices will reduce net worth, which boosts the financing premium and magnifies the effects of the asset price shock on the economy.
To demonstrate the role of this mechanism in their open economy model, the authors carry out a series of exercises. First they consider an increase in foreign interest rates. When the domestic central bank is enforcing a fixed exchange rate, it is forced to raise domestic (nominal and real) interest rates in response. Higher rates cause domestic asset prices to fall, which raises the leverage ratio and borrowers’ financing costs. As a consequence, investment and output both fall. In contrast, when exchange rates are flexible, domestic interest rates do not have to go up as much because the domestic currency is allowed to depreciate, which mitigates the fall in domestic investment and output.
Such a difference in outcomes under fixed and flexible exchange rate regimes would emerge even in a model without a financial accelerator. However, the authors show that the presence of the financial accelerator magnifies the declines in the real economy under fixed exchange rates.
The McCallum paper considers a variety of theoretical and empirical issues regarding the liquidity trap, which occurs during a persistent deflation when nominal short-term interest rates fall to their zero lower bound. In these circumstances, the central bank is in a liquidity trap because it can no longer ease policy by lowering interest rates (see Hutchison 2000). McCallum argues that a liquidity trap is unlikely to be a very common or insurmountable problem.
As a general theoretical issue, he notes that the liquidity trap in many models would not occur if agents were partially (or boundedly) rational and constructed their forecasts of inflation using sensible algorithms. In particular, if the agents learn from past data, they will not encounter a liquidity trap.
However, in the real world, as a practical matter, even if a liquidity trap were encountered, McCallum argues that the central bank would not be powerless to defuse it. Although the usual interest rate channel to stimulate the economy is immobilized, monetary policy may still be potent because of the existence of a transmission channel involving foreign exchange. Indeed, the author proposes that a central bank could stimulate recovery from the liquidity trap by using base money to purchase foreign currency and thereby depreciate the home currency and raise net exports. This type of policy will not work if the exchange rate is governed by the interest rate parity condition discussed above. However, the author notes that this condition has weak support in the data and in theory.
Glenn D. Rudebusch
Batini, Nicoletta, Richard Harrison, and Stephen P. Millard. “Monetary Policy Rules for an Open Economy.” Bank of England Working Paper.
Gertler, Mark, Simon Gilchrist, and Fabio Natalucci. “External Constraints on Monetary Policy and the Financial Accelerator.” New York University and Boston University.
Goodhart, Charles, and Boris Hofmann. “Asset Prices, Financial Conditions, and the Transmission of Monetary Policy.” London School of Economics and University of Bonn.
Leitemo, Kai, and Ulf Söderström. 2001. “Simple Monetary Policy Rules and Exchange Rate Uncertainty.” Sveriges Riksbank Working Paper.
McCallum, Bennett. “Inflation Targeting and the Liquidity Trap.” Carnegie-Mellon University.
Stock, James H., and Mark W. Watson. “Forecasting Output and Inflation: The Role of Asset Prices.” Harvard University and Princeton University.
Dennis, Richard. 2001. “Monetary Policy and Exchange Rates in Small Open Economies.” FRBSF Economic Letter 2001-16 (May 25).
Hutchison, Michael. 2000. “Japan’s Recession: Is the Liquidity Trap Back?” FRBSF Economic Letter 2000-19 (June 16).
Taylor, John, ed. 1999. Monetary Policy Rules. Chicago: University of Chicago Press.
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