Should monetary policy respond to asset prices and asset bubbles? This is a highly controversial issue, both from an academic research point of view and, more importantly, from a policy perspective. Given the broad evidence that asset bubbles do occur from time to time, and that such bubbles may lead to economic distortions as well as financial and real economy instability, many authors have argued that optimal monetary policy requires monetary policy authorities to react to such bubbles over and above the effects that such bubbles have on current output growth, aggregate spending and expected inflation. Other authors are of the view that monetary policy should not react to asset prices or bubbles beyond the effect that such asset price movements directly have on inflation, aggregate spending and economic growth. I have recently written a paper (available here for registered RGE subscribers) where I argue that monetary policy should react to asset prices and asset bubbles. 

This is not an academic issue: twice in the past ten years the Fed has had to decide how to respond to sharp rises in the price of key assets. Considering recent U.S. economic history, it is obvious, in hindsight, that some of the surge in stock prices in the mid-late 1990s was excessive and beyond what was warranted by economic fundamentals. U.S. Fed Chairman Alan Greenspan warned against "irrational exuberance" in stock markets as early as the fall of 1996 but then, apart from a half-baked attempt to increase the Fed Funds rate by 25bps in the spring of 1997, the Fed did not further react to this asset bubble that eventually crashed in 2000. Similarly, the Fed has explicitly resisted the idea of adjusting monetary policy in the face of regional housing bubbles that developed in the last few years in a broad enough swath of the U.S. to have a big impact on the overall economy.

Recently, Greenspan and other Fed officials (see Greenspan (2005a) and Kohn (2005)) have expressed greater concern about such a housing bubble and on its effects on the national savings rate and the U.S. current account balance: "Nearer term, the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely. The surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports, and a corresponding improvement in the current account deficit." (Greenspan (2005a))

But the Chairman of the Fed has remained skeptical of whether the Fed should be reacting to such bubbles (Greenspan (2005b): "Debates on the relative merits of asset price targeting also will continue and possibly intensify in the years ahead. The configuration of asset prices is already an integral part of our evaluation of the large array of forces that influence financial stability and economic growth. But given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset prices any time soon. However, I certainly do not rule out that future work could improve our understanding of asset price behavior, and with it, the conduct of monetary policy."

Indeed, Greenspan (1999, 2002, 2004, 2005a, 2005b) as well as other current and former Fed officials (Bernanke (2002, 2003), Bernanke and Gertler (1999, 2001),  Kohn (2004, 2005), Ferguson (2005)) have articulated - over the last few years - a series of arguments against targeting asset prices in the conduct of monetary policy; and they have used these arguments to explain or justify why the Fed did not react to the "irrational exuberance" of the late 1990s in spite of the fact that such bubble eventually burst in 2000 and that this crashing bubble and the investment bust that followed it was the major reason behind the economic recession of 2001.

In the recent paper I have written on the subject of monetary policy and asset prices (available here for registered RGE subscribers), I analyze and refute these Fed arguments against the use of monetary policy to target asset bubbles: there are many good arguments in favor of such targeting while the arguments against it are, in many dimensions, not robust. In summary, the main arguments in favor of monetary policy targeting of asset prices and asset bubbles are as follows.