Effects of Federal Reserve Monetary Policy on the US Asset Prices - Literature review Example

Effects of Federal Reserve Monetary Policy on U.S. Asset Prices Introduction Asset prices are usually characterized as endogenous variables. In capitalist markets with no regulatory distortions asset prices are viewed as indicators providing useful information about the economic state of a particular country as their volatility would reflect changes in underlying economic fundamentals (Bernanke & Gertler 1999, 19). However, sometimes asset values seem to be disconnected from the existing model of a given economy (Bernanke & Gertler, 1999). Assets prices including the prices of equities, residential housing, commercial real estate, and others have been reflecting both busts and boosts during the past two decades in various countries (Bernanke & Gertler, 1999). Recent global financial crisis of 2008 has once again raised questions related to the reasons of it and gaps, which should be covered in future (Issing 2009). Many researchers have addressed the problem fluctuations in asset prices by analyzing the influence of the monetary policies and other relevant factors. Bernanke & Gentler (1999) have explained that asset price volatility might have significant impact on the real economy and its instability. Issing (2009) also has addressed the issue of relationship between asset prices volatility and monetary policies implemented by central banks. Doh and Conolly (2013) have examined how communication of the Federal Reserve in relation to its plans for implementing monetary policy influences the asset prices. The aim of this research is to provide a more detailed literature review of the studies carried out by the above mentioned authors, and based on the information retrieved from the studies to analyze how the Federal Reserve Monetary Policy and relevant announcements impact on the U.S. Asset prices. Article Summaries Issing (2009) in his article “Asset Prices and Monetary Policy” explains the role the central banks play in ensuring prices’ stability. He explains that there are three key principles related to the role of central bank in relation to asset prices, including the following: not target asset prices; not try to prick a bubble; and following a “mop up” strategy in case of the burst of a bubble by insuring enough liquidity to the market (Issing 2009, 46). As the first two principles are unquestionable, Issing (2009) focuses on the third principle and explains that because of lack of effective instruments, a central bank cannot effectively target asset prices. Thus, it appears, that central bank should issue monetary policy in case if the collapse of asset prices has already occurred rather than take active role in preventing this situation. While Issing (2009) challenges the assumption that central bank should possess better knowledge on the true price (valuation) of specific assets, he believes that they can communicate their concerns and predictions related to strong increases in asset prices in relatively long-term perspective. Further, the author refers to the financial crisis to criticize inefficient role of the central bank in relation to managing an asset price market and prevention of the asset price bubble (Issing 2009). Issing (2009) also criticizes the Jackson Hole Consensus stressing the asymmetry of this monetary policy strategy. In case of a broad collapse of asset prices there may be no alternative to the third principle (a mop up strategy), making monetary policies not sufficient enough for recovery. Issing (2009) believes that it is better to adopt forward-looking approach in the process of adopting monetary policies. The focus of central bankers should be made on ensuring price stability, and keeping inflation rate low and stable. Issing concludes that a monetary policy strategy based on close monitoring of monetary and credit developments could limit the emergence of asset prices volatility (2009). Historical evidence shows that excessive growth of money and credit was the main contributor or even driver of the asset price bubble. Thus, monetary policy strategy focused on monitoring money and credit and analysis of the market situation might prevent both asset price increases and declines (Issing 2009). Moreover, this approach enables central bankers to better assess the correctness of the policy’s state. Bernanke & Gertler (1999) conducted a research study to explore the issue of how monetary policy makers should address the problem of asset prices variability. The authors focus on the problems related to the various negative economic consequences, which might arise in case if there is no appropriate monetary policy. Bernarke & Gertler (1999) have examined the effect of some monetary policies with a focus made on policies implemented during the financial recessions. The researchers believe that monetary policy by itself should not be viewed “sufficient tool to contain the potentially damaging effects of booms and busts in asset prices” (Bernarke & Gertler 1999, 17). However, unresponsiveness of monetary policy or actively reinforced deflationary pressures lead to the asset crashes with significant negative economic consequences. Bernarke & Gertlet (1999) the same as Issing (2009) believe that it is the responsibility and one of the key objectives of the central banks to treat price stability and financial stability. It has been suggested that both general macroeconomic stability and financial stability could be achieved with a utilization of an effective unified framework known as inflation-targeting (Bernarke & Gertlet 1999). This framework implies that monetary policy should not respond to changes in asset prices. Exception of this approach relates to the situations when monetary policies help to forecast deflation or inflation. By arguing for this approach, Bernarke & Gertler (1999) explain that central banks can use inflation targeting in order to increase the interest rates during asset price booms, and decrease interest rates during asset price busts. Inflation targeting implies that monetary policy has to adhere to the three main principles: commitment to achieving a specific level of inflation ensuring long-run price stability; flexibility within the constraints of the long-run inflation target aiming to achieve relevant objectives in short-run; and transparency and openness of the monetary policy making process to public (Bernarke & Gertler 1999). The authors believe that the Federal Reserve policy adhered to the first two principles listed above, but failed to adhere to the third one. Doh and Conolly (2013) explain that in addition to the communication of the Federal Reserve in relation to its plans for implementing monetary policy, the Federal Open Market Committee provides public with forward guidance on the expected federal funds rate. The main idea of such a FOMC’s communication was to provide guidance to the private sector’s expectations of future short-term interest rates, thus enabling investors to adjust asset prices in accordance with the objectives reported by the FOMC (Doh and Conolly 2013). The authors have carried out a study analyzing what impact the monetary policy announcements has on asset prices (Doh & Conolly 2013). As the changes in policy guidance influence the expectations of the private sector including stock prices, bond yields, and other assets, Doh & Conolly analyze the progress of the forward guidance about the likely path of the federal funds rate and the effect it has in relation to the asset prices (2013, 31). There are identified two key channels through which policy announcements can affect asset prices, including: announcements about the future path of monetary policy and news about discount rate used in the asset’s valuation (Doh & Conolly 2013). Having analyzed both factors and historical data, Doh & Conolly (2013) have come to conclusion that while there has been established a correlation between the policy guidance and change of asset prices, its effect on both bond yields and stock prices has decreased after the global financial crisis in 2008. However, there are recognized two different reasons for the weaker response of bond yields and stock prices. The response of bond yields to policy announcements was stronger than the response of stock prices (Doh & Conolly 2013). The authors accept that there is lack of clear evidence of informational advantage of the FOMC’s announcements of monetary policy changes; however, they suggest that the investors possessing private and imperfect information might have adopted their behavior to the economic outlook given in FOMC’s announcement (Doh & Conolly 2013). Synthesis Based on the review of three articles it is possible to conclude that the Federal Reserve Monetary policy may have direct effects on the U.S asset prices. All authors have referred to financial crisis to illustrate the mechanisms of influence on the monetary policies on the asset valuation. Issing believes that central bankers should focus on prevention of asset prices collapse rather than try to issue monetary policy in case if the collapse of asset prices has already occurred. Issing and suggest that the focus of central bankers should be made on ensuring price stability, and keeping inflation rate low and stable. According to Issing (2009) a monetary policy strategy based on close monitoring of monetary and credit developments could limit the emergence of asset prices volatility (Issing 2009). However, Bernarke & Gertler (1999) explain that monetary policy by itself is not enough for managing booms and busts in asset prices. This concept enables to conclude that Federal Reserve monetary policy has effect on the asset prices but other factors should be taken into consideration (not relevant to the current topic and should be reviewed separately). One of the measures aimed to achieve both general macroeconomic stability and financial stability is recognized to be inflation-targeting (Bernarke & Gertlet 1999). All authors believe that it is critical to communicate the concerns, predictions related to asset prices changes and to discuss openly the proposed and actual plans on monetary policies with public. While Bernarke & Gertlet (1999) recognized the necessity of effective communication on monetary policies with the public they stated that the Federal Reserve to adhere to do it. However, taking into consideration the year when the article was published it is possible to suggest that this problem has been resolved with time. As Doh and Conolly (2013) explain there is set effective communication on behalf of the Federal Open Market Committee (FOMC), which provides public with forward guidance on the expected federal funds rate. However, despite the announcements made by the FOMC, there is evidence that the effect of these announcement on both bond yields and stock prices has decreased after the global financial crisis in 2008. The articles reviewed in this paper provide some concepts and theories related to the effects of Federal Reserve monetary policy and its announcements on the U.S. asset prices, however, all the sources focus on different aspects and are not perfectly tied to the same theme. References: Bernanke, B., & Gertler, M. (2000). Monetary policy and asset price volatility. Federal Reserve Bank of Kanzas City. Doh, T., & Connolly, M. (2013). Has the effect of monetary policy announcements on asset prices changed?. Federal Reserve Bank of Kansas City, Economic Review, Third Quarter. Issing O. (2009). Asset Prices and Monetary Policy. Cato Journal, Vol.29, No.1 (Winter 2009). Read More