Relationship between Monetary Policy and Asset Prices - Literature review Example

Relationship between Monetary Policy and Asset prices: Evidence from UK and US Introduction Asset costs as dictated by market patterns are a sensitive indicator of economic performance at various economic times. Economic interventions are formulated to control economic performance factors and instigate economic protection in times of uncertainty. One of such interventions is the monetary policy which targets money circulation and supply within the economy and is aimed at instilling economic stability as well as economic growth. Market patterns have various observable changes in the economy one of which is inflation, which is represented by increases in prices of goods, assets and services during a specified period of time. It is usually represents the monetary unit purchasing power erosion as a factor of certain temporal conditions. Havoc can result to the economy in times of unprecedented changes in the prices of goods within the economy and the economy must act to stabilize the economy, which is done by the monetary authority on a constant watch (Handa, 2008, p420). The action of the central bank to intervene in times of heightened inflation or to allow the markets to stabilize on their own is a topic of debate among economists for a long time. One section of economists proposes that the government monetary policy should not make the mistake of intervening when inflation bites due to the lack of consensus that the costs of inflation are substantially harmful. This section of economists oppose disinflation attempts on a number of reasons as asset prices are an important aspect of the equation, thereby protecting the general market forces to stabilize. As many economists are however of the opinion that the costs of inflation are indicators of serious difficulties in the asset market and recommend that immediate action should be taken to protect the asset market from devastation. To summarize these two positions, Bernanke and Cecchetti are notoriously famous for having postulated substantial claims in this debate each on the opposite side. a) Bernanke: Central banks should not respond to movements in asset prices unless these movements are predicting future changes in inflation In principle, economic performance should not be subjected to a range of monetary manipulations without a clear assurance that the targeted condition will result in undesirable inflationary impact to the economy. In Grunwald (2010), Bernanke is reported to be among the few individuals holding the opinion that ambushing a little inflation detected in the economy is not necessarily beneficial to the economy. The author reckons that this position by Bernanke implies that inflation is not as always evil in the economy as most proponents of immediate monetary intervention to inflationary patterns argue. Having a very strong currency in the economy is also not as beneficial as most proponents of inflationary control would love to imagine. One of the main arguments that Bernanke postulates towards the support of leniency and a cautious approach towards dealing with inflation using monetary policy is its temporal occurrence and a part of the market. By involving a lot of disturbances to the economic patterns observed in the asset markets, the economy would be undergoing more harm than benefits. Inflation affects more than one elements of economic outlook among which are nominal income and commodity prices. The direct impact of inflation is usually called for by economic variables that are not necessarily indicative of the real inflationary burden. According to Mankiw (2008, p421), it is important to weigh up the cost benefits of reducing inflation since it also incurs some economic costs. According to the author, social costs of disinflation may be undesirable to a majority who would disproportionately bear the burden when considering equitable distribution. It is likewise important for other economic interventions to be assessed and tried out in place of disinflation which is usually temporal and almost costly to intervene. Bernanke (2010, p6) holds the opinion that employing monitory policy to control inflation should only be considered if the expected benefits are more than the costs. Censky (2011) reckons that Bernanke holds on to the premise that if inflation becomes aggravated beyond the expected time patterns, it could be detrimental and such a time is prudent for monitory intervention being considered. b) Cecchetti: including asset price movements in the monetary policy rule contributes to refine monetary policy Perhaps one of the most outspoken proponents of the position that the central bank ought to intervene and induce inflation reduction measures rather than wait for the economic to achieve its stability undisturbed is Stephen Cecchetti. According to Cecchetti, the role of the monetary policy is to crack the whip immediately the prices start to show signs of hyperinflation which is detrimental to any economy (Cecchetti, 1998). The central bank has a direct role in making sure that price stability is achieved by arresting the rising patterns of asset prices immediately they are witnessed. The central bank must be keen to notice inflationary and deflationary patterns in order to alter the monetary policy in a protectionist move by involving three main tools namely; adjusting commercial banks’ reserve requirements, adjusting lending rates and trading in government securities and instruments (Cecchetti, 1998, p8). Regarding the 2008-2009 financial crisis, Cecchetti (2008, p26) reckons that the failure by the Federal Reserve to incorporate the necessary monitory policy measures in the interventions must bear the blunt for the losses experienced. Skyrocketing asset prices at the beginning of 2007 should have acted as enough indicators to warrant a bold move by the Federal Reserve to institute inflation target measures to quell the predictable predicaments on not only the US economy but that of the entire world also. Cecchetti, Chu and Steindel (2000, p1) however reckon that the actual reliability of inflationary patterns is a difficult process with the available cues being not always perfect as expected. The magnitude of the spectrum of inflation indicators is so wide such that it becomes nearly difficult to monitor al the loopholes in the cases that result in detrimental impacts to the economy. In light of these difficulties, it becomes elusive for the authorities to determine the actual point in time when monitory policy is necessary for application as an intervention. The authors propose that the variables can be classified into a forecasting model which can reliably be used to make the necessary policy input and correct the difficulties. In the classification of these variables, the authors provide three classes which include commodity prices, financial indicators and real economy indicators. By following the cues left by these variables which must be in a coherent manner, the central bank is well positioned to eradicate any unfavourable impacts of inflation on the economy. In emerging markets and other economies such as the UK, it is a major routine to incorporate certain inflation targets that contain the rate at a minimum figure for the financial year ahead (Mishkin, 2001, p1). Summary Taylor Rule Both sides of the debate agree that that the monitory policy tools to curb inflation must come into play at one point of the inflationary cycles. However, it is not as clear as John B. Taylor postulated in 1993 in the famous Taylor rule on the exact magnitude of input that the central bank should make to arrest inflation. According to the Taylor rule, rises in inflation by a percentage point must attract intervention by the central bank through inverse reaction on nominal interest rate by more than a percentage point. In this case, a balance should always exist between the two parameters based on a number of other variables which include; rate of inflation measured through GDP deflator, a specified inflation range or desirable rate, an equilibrium real interest rate that is derived from a number of assumptions, the real GDP as well as potential output. it = it*+πt + α(πt-πt*) + β(yt-yt*) (Astar and Caglayan, 2010, p57) All these variables were applied in an equation that is famously referred to as Taylor rule (Handa, 2008, p358). According to the author, the main objectives of the Taylor rule are those targeted at inflation in relationship to stabilizing its targeted rate while maintaining high output at a given level of employment. Taylor rule emphasizes on the use of one of the three monetary tools described by Cecchetti earlier in the text which employs interest rate adjustment to respond to inflation patterns. Under the rule, the Federal Reserve is supposed to set its target for monitoring inflationary impact using a number of indicators. Both Cecchetti and Bernanke agree that following one reliable economic indicator of inflation is not sufficient and the temporal aspect of inflation uncertainty also complicates this type of regulation. Strict regulation is therefore a major characteristic in the model proposed by Cecchetti as well as in inflation target systems which highly follow the performance of the economy through changes in inflation. Empirical Literature In both the UK and the US, different tools of arresting inflation are employed, but there is evidence of application of non linear rules across the economies (Cukierman and Muscatelli, 2008). Policy differences are available due to some level of asymmetric preferences adopted by different central banks. It is completely impossible for economies to agree to practice Taylor rule in exclusivity due to the availability of newer versions of the rule, mainly derived from the main Taylor rule to expound on different economic scenarios and factors. One of the most acceptable modifications of the Taylor rule that applies in many economic interventions includes the Keynesian framework. In this framework, it is expected that when the central bank manages and keeps the inflation under control, output deviations from set targets and fluctuations are likewise managed. It therefore follows that the output levels are managed at the time of monetary input and interest rate manipulation is not intended to bring around any direct output changes. Other modifications introduce some extra function variables to the Taylor rule to make some important elements of the economy felt in the policy (Astar and Caglayan, 2010, p56). Some of these variables in modified equations include raising interest rates during rising trends in stock prices and increases in the housing sector. In finding direct relationship between the two debaters included in this discourse with regard to the position taken in Taylor rule, the propositions therein are met easily in Cecchetti’s argument than it is with Bernanke. According to Cecchetti, it is important that the authorities control inflationary patterns at the earliest instance possible, which boils down to the policy regime and its implementation. Due to the fact that there are various regime approaches to the issue of policy implementation, Taylor rule cannot completely be followed in entirety. In the two countries under consideration in this discourse, it is evident that the UK employs inflation targeted approach in dealing with asset prices in the market while on the other hand it is clear that the US is reluctant to introduce direct inflation targeted approach for monitory policy involvement (Krehm, 2000, p116). Perhaps one of the explanations that the US economy can have on its line of policy regulation for inflation can found in its application of other alternatives that protect the economy from the impacts of monitory interventions. Dealing with unemployment is one of such challenges that are avoided in implementing inflation control (Handa, 2008, p430). Three elements of the debate hold true throughout the debate and act as the real determinants of the final decision taken by the policy makers. Firstly, interest rate ad defined by the nominal interest rate in the Taylor equation is very important for the monetary policy formulation. Secondly, output as defined by full employment levels within the economy also plays an important role in the determination of the appropriate policy input needed at a particular time. Thirdly, inflation as depicted by temporal rises in costs of commodities carries the broadest meaning in the deliberations. In the debate of how monetary policy should be involved in the intervention of inflation, it is clear that both sides agree that a number of variables are involved in the decision making process. Aggregate demand is dependent on the interest rate which operates in an inverse relationship. Reduction in aggregate demand by induction mechanism of monetary policy ultimately lowers the effective inflation, to sustain an inverse relationship to that level. References Astar, M. & Caglayan, E. (2010) Taylor Rule: Is it an Applicable Guide for Inflation Targeting Countries? Journal of Money, Investment and Banking, no. 18 (2010) pp. 55-67 Bernanke, B. S. (2010) Monitory Policy Objective and Tools in a Low-Inflation Environment. Business Review, vol. 135 no. 1 pp. 1- 8 Cecchetti, S. G. (1998) Central Bank Accountability in Formulating Monetary Policy. [online] Available from: [accessed 9 August 2011] Cecchetti, S. G. (2008) Monetary Policy and the Financial Crisis of 2007-2008. [online] Available from: [accessed 9 August 2011] Cecchetti, S., Chu, R. & Steindel, C. (2000) The Unreliability if Inflation Indicators. Current Issues in Economics and Finance, vol. 6 no. 4 pp. 1-6 Censky, A. (2011) Bernanke: Inflation Risk Modest. CNN Money [online] Available from: [accessed 9 August 2011] Cukierman, A. & Muscatelli, A. (2008) Nonlinear Taylor Rules and Asymmetric Preferences in Central Banking: Evidence from the United Kingdom and the United States, The B.E. Journal of Macroeconomics, vol. 8: no. 1 (Contributions), Article 7. DOI: 10.2202/1935-1690.1488 Available from: [accessed 9 August 2011] Grunwald, M. (2010) Bernanke’s Bum Rap: Why a Little Inflation is Good. Time US Magazine [online] available from: [accessed 9 August 2011] Handa, J. (2008) Monetary economics. Abingdon, OX: Routledge Publishers Krehm, W. (2000) Meltdown: how zero inflation policy is leading the world’s monetary economic systems to collapse. Toronto, ON: COMER Publications Mankiw, N. G. (2008) Brief principles of macroeconomics, Belmont, CA: Cengage Learning Mishkin, F. S. (2001) Inflation Targeting. [online] available from: [accessed 9 August 2011] Read More