Should the federal reserve have responded to asset prices?

Abstract

Determining strategies for taking into account movements in asset prices is a perennially important issue for central banks. In this paper, an analysis is provided to address this issue for the U.S. economy. To do so, an empirical model of the U.S. economy is constructed and estimated, and the estimated model is simulated with a set of alternative monetary policy rules. Comparing the stabilization performance of the rules, it is found that: i) by responding to a larger set of policy indicators and taking a more aggressive stance toward inflation and output gap in particular, the Federal Reserve could have achieved a much higher degree of stabilization; ii) had the Federal Reserve responded to its historical policy indicators differently, it could have conducted a near-optimal policy rule, even without taking into account movements in housing and stock prices; iii) the Federal Reserve could have likewise achieved close-to-optimal stabilization results by properly responding to movements in asset prices, on top of its historical policy scheme; and iv) stock price inflation contains more useful information that helps further stabilize the economy than does housing price inflation.