Volume 16, Number 1 Article by Rohit Seksaria and Rajiv Rangarajan March, 2004
Monetary Policy Indicators and Asset Price Bubbles :
The successful implementation of the monetary policy requires the effective use of indicators or intermediate targets. While a wide variety of indicators are used, measures of inflation such as Consumer Price Index (CPI), Wholesale Price Index (WPI) and Producer Price Index (PPI) are the most popular. However, these simple indicators break down during boom-bubble-bust cycles, as was seen in the US and Japan, both of which witnessed asset prices bubbles. Therefore, there is a need for alternate indicators that remain robust even during such unstable periods and also track asset price movements.
In this study, Rohit Seksaria and Rajiv Rangarajan build several models involving techniques such as trimming, lagging, and using a basket of indicators. One such model is based on variations in CPI, share prices, exchange rates, housing prices, and past GDP. The authors have tested this model for the US and Japan and their data analysis reveals that it serves the twin requirements of robustness, and factoring in asset prices. It also acts as a lead indicator since it uses one-year lag data.
Central Banks are often accused of being reactive rather than proactive in policy formulation, but this is primarily because of the difficulty in telling a speculative bubble from a genuine one. Appropriate timing of intervention is one of the biggest challenges facing Central Bankers, especially during boom times. By the time the Central Bank decides to act, the economy may be heated up beyond control (as it happened in the US and Japan), and then the magnitude of intervention required becomes so large that the intervention hurls the economy into a recession. The asymmetric response to asset price changes leads to a moral hazard problem. By providing better forecasts, the suggested model can reduce the timing dilemma and the moral hazard problem. It can alleviate this difficulty by linking it to the monetary transmission channel. However, clear structural models linking it to the monetary channels have not been developed and further research is required to establish these structural relationships. The model would also be applicable in the Indian context but with minor modifications.
Reprint No 04104
