Housing Prices and Robustly Optimal Monetary Policy

We analytically characterize robustly optimal monetary policy for an augmented New Keynesian model with a housing sector. In our setting, the housing stock delivers a service flow entering households’ utility, houses are durable goods that depreciate over time, and new houses can be produced using a concave production technology. We show that shocks to housing demand and to housing productivity have “cost-push” implications, which warrant temporary fluctuations in the inflation rate under optimal policy, even under an assumption of rational expectations, for reasons familiar from the literature on “flexible inflation targeting”. However, under rational expectations optimal monetary policy can still be characterized by commitment to a “target criterion” that refers to inflation and the output gap only, just as in the standard model without a housing sector. Instead, if policy is to be robust to potential departures of (house price and inflation) expectations from model-consistent ones, the target criterion must also depend on housing prices. In the empirically realistic case where the government subsidizes housing, the robustly optimal target criterion requires the central bank to “lean against” unexpected increases in housing prices, in the sense that it should adopt a policy stance that is projected to undershoot its normal targets for inflation and/or the output gap owing to the increase in housing prices, and similarly aim to overshoot those targets in the case of unexpected declines in housing prices