MONETARY POLICY AND STOCK MARKET BOOMS

Historical data and model simulations support the following conclusion. Inflation is low during stock market booms, so that an interest rate rule that is too narrowly focused on inflation destabilizes asset markets and the broader economy. Adjustments to the interest rate rule can remove this source of welfarereducing constructing the inflation forecast) would reduce the volatility of output and asset prices. Lawrence Christiano Department of Economics Northwestern University 2003 Sheridan Road Evanston, IL 60208 and NBER l-christiano@northwestern.edu Cosmin L. Ilut Duke University 213 Social Sciences Bldg. , Box 90097 Durham, NC, 27708 cosmin.ilut@duke.edu Roberto Motto European Central Bank Postfach 16 03 19 D-60066 Frankfurt am Main GERMANY roberto.motto@ecb.int Massimo Rostagno European Central Bank Postfach 16-03-19 D-60066 Frankfurt am Main GERMANY Massimo.Rostagno@ecb.int 1. Introduction and Summary The interaction between monetary policy and asset price volatility has been a matter of increased concern since the collapse of stock market booms in 2000 and 2007. Are booms like these suboptimal? Is monetary policy partially responsible for stock market booms? Should monetary policy actively seek to stabilize stock market booms? These classic questions have been put back on the table by the experience of the past two decades. 1.1. The conventional wisdom There is, we believe, a conventional wisdom on the answers to these questions. Booms arise for reasons largely unrelated to the conduct of monetary policy. Some booms are indeed excessive. But, it is unwise to identify which booms are excessive and to actively resist them using interest rate policy. The conventional wisdom is that, in any case, a strategy of raising the policy interest rate when the ination forecast is high and reducing it when the ination forecast is low should help to dampen excessive volatility. The notion is that booms which are excessive involve a rise in stock prices above levels justi ed by fundamentals. Such a boom represents a surge in demand because there is nothing currently on the supply side of the economy to justify it. In a demand boom, however, one expects ination to be high. The policy of ination forecast targeting using an interest rate rule leans against the boom at precisely the right time. This conventional wisdom was given an intellectually coherent foundation in two very inuential papers (Bernanke and Gertler (1999,2001)). 1.2. Data We explore an alternative perspective on the relationship between monetary policy and booms. We are motivated to consider this alternative by the historical record of United States (US) stock market booms as well as by the Japanese stock market boom of the 1980s. We nd that ination was relatively low in each of the 18 US stock market boom episodes that occurred in the past two centuries.1 The Japanese case is particularly striking, with ination slowing sharply during the boom from its pre-boom level. The notion that stock market booms are not periods of high ination, and that they are if anything periods of low ination is not new to this paper. The recent work of Adalid and Detken (2007), Bordo and Wheelock (2004, 2007) and White (2009) also draws attention to this observation. Here, we stress the implications for monetary policy. The historical record suggests that, at least at an informal level, a monetary policy which implements ination forecast targeting using an interest rate rule would actually destabilize asset markets. The lower-than-average ination of the boom would induce a fall in the interest rate and thus amplify the rise in stock prices in the boom. A noticeable feature of stock market booms is that, with the exception of only 2 of the 18 booms in our US data set, credit growth is always stronger during a boom than outside a boom. On average, credit growth is twice as high in booms than it is in non-boom periods. Casual reasoning suggests that volatility would be reduced if credit growth were tightened as booms get underway. In practice, this tightening in response to credit growth would not 1We exclude the Civil War and WWI and II from our dataset.