FRBSF Economic Letter
2001-18; June 15, 2001
Asset Prices, Exchange Rates, and Monetary Policy
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.frbsf.org/economics/conferences/0103/index.html.
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.
Forecasting output and inflation: the
role of asset prices
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
Asset prices, financial conditions,
and the transmission of monetary policy
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
Simple monetary policy rules and exchange rate
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.)
Monetary policy rules for an open economy
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.
External constraints on monetary policy and
the financial accelerator
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.
Inflation targeting and the liquidity trap
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
Senior Research Advisor
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
McCallum, Bennett. "Inflation Targeting and the Liquidity Trap."
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). http://www.frbsf.org/publications/economics/letter/2001/el2001-16.html.
Hutchison, Michael. 2000. "Japan's
Recession: Is the Liquidity Trap Back?" FRBSF Economic Letter
2000-19 (June 16). http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-19.html.
Taylor, John, ed. 1999. Monetary Policy Rules. Chicago: University
of Chicago Press.
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