Monetary Policy and Asset Price Booms: A Step Towards a Synthesis

Abstract

Should a monetary policy maker following a Taylor-type rule set a higher policy rate than the level suggested by the rule because of a possibility of an asset price bust in the near future? Our answer to this question for monetary policy makers who have two scenarios of 'boom-bust cycle' and 'stable growth' is yes if the following two conditions are satisfied. First, early warning indicators based on credit and residential investment data show a high probability of a boom-bust cycle occurring. Second, the policy rate path that minimizes the boom-bust probability-based expected value of a social loss associated with inflation and the output gap over the two scenarios is higher than the rate path by the Taylor-type rule. Our counterfactual analysis shows that the Fed should have raised the federal funds rate by a small amount over and above the level suggested by a Taylor-type rule in the early 2000s.