On the interaction between asset prices, inflation and interest rates

This thesis examines the interaction between monetary policy, inflation and asset prices. The role of asset prices in the transmission mechanism of monetary policy via consumption wealth effects and investment balance sheet effects is receiving a growing degree of attention nowadays. Financial asset prices respond quickly to new information about monetary policy shifts, while the transmission of policy actions to output and inflation exhibits significant lags. Therefore, it is important to examine the feedback between interest rates and asset prices, since it will provide important insights for central bankers and investors alike. This area of the literature draws from both the monetary economics and financial economics disciplines and has become quite important given the new challenges for monetary policyrnakers in the context of fundamental changes in the underlying financial and macroeconomic framework. In this respect, we are interested in three main issues: first, to investigate the impact of the, nowadays prevalent, inflation targeting monetary policy regime on average inflation and the related inflationary uncertainty (Chapter 2); second, to establish quantitatively the existence of a transmission link from changes in the monetary policy stance to the stock market (Chapter 1); third, to examine the monetary policy reaction to asset price fluctuations (Chapters 3-5). Chapter 2 looks at the significant changes that occurred in the inflation process over the 1990s using British data. We show that post-targeting, inflation is lower, less persistent and less volatile. In chapter 3, we use data from the UK and the US and find that lower expected inflation allows monetary policy to relax by decreasing short-term interest rates. In chapter 1, international evidence suggests that decreases in interest rates exert a significantly positive impact on stock prices in the majority of the countries under investigation. Hence, the empirical evidence in chapters 1-3 is consistent with the scenario underlying the so-called 'new environment' hypothesis. Inflation targets were successful in anchoring inflation expectations and subsequently boosting stock prices due to lower interest rates. In chapters 3-5 we focus on the role of asset prices for monetary policy formulation. We present empirical (chapter 3), theoretical (chapter 4), and simulation n(chapter 5) evidence indicating that monetary policy has responded and should, in principle, respond to asset price fluctuations. Particularly, in chapter 3 we augment the standard forward-looking Taylor rule with the change in asset prices (house prices, stock prices) and find that there is a positive and statistically significant weight attached to asset price fluctuations in both the UK and the US. The estimates suggest that policyrnakers in the US are more concerned about stock market developments, while in the UK about house market developments. In chapter 4, we utilise a structural backward-looking economic model, augmented for the effect of asset prices on aggregate demand, that allows us to derive the optimal interest rate rule via dynamic minimisation of the central bank's loss function. We show that under certain assumptions about the asset price evolution, monetary policy should react to asset price misalignments from their fundamental value. Finally, in chapter 5 we simulate a forward-looking model to examine the impact on macroeconomic volatility from reacting, or not, to asset price misalignments. We find that a policy reaction that is aggressive with respect to inflation, and mild (but not zero) with respect to asset price misalignments is able to promote overall macroeconomic stability.EThOS - Electronic Theses Online ServiceGBUnited Kingdo