Do credit market imperfections justify a central bank׳s response to asset price fluctuations?

Do credit market imperfections justify a central bank׳s response to asset price fluctuations? This study addresses this question from the perspective of equilibrium determinacy. In the model we use, prices are sticky and the working capital of firms is subject to asset values because of a lack of commitment. If credit market imperfections exist to a small degree, the Taylor principle is a necessary and sufficient condition for equilibrium determinacy, and monetary policy response to asset price fluctuations is good from the perspective of equilibrium determinacy. However, if credit market imperfections exist to a large degree such that the collateral constraint is binding, then the Taylor principle no longer guarantees equilibrium determinacy, and monetary policy response to asset price fluctuations becomes a source of equilibrium indeterminacy. We find that the existence of credit market imperfections makes it unsuitable to initiate a monetary policy response to deal with asset price fluctuations. We also find that reductions in credit market imperfections can enlarge the indeterminacy region of the model parameters.     

MONETARY TRANSMISSION MECHANISM IN CENTRAL AND EASTERN EUROPE: SURVEYING THE SURVEYABLE

Abstract.  This paper surveys recent advances in empirical studies of the monetary transmission mechanism, with special attention to Central and Eastern Europe (CEE). Our results indicate that the strength of the exchange rate pass-through substantially declined over time mainly due to a fall in inflation rates and to some extent due to the so-called composition effect. The asset price channel is weak and is likely to remain weak because of shallow stock and private bond markets and because of low stock and bond holdings of domestic households. House prices may become an exception with booming mortgage lending and with high owner occupancy ratios. While the credit channel could be a powerful channel of monetary transmission – as new funds raised on capital markets are close to zero in CEE – it is actually not, as both commercial banks and non-financial corporations can escape domestic monetary conditions by borrowing from their foreign mother companies. The moderately good news, however, is that those banks and firms are influenced by monetary policy in the euro area because their parent institutions are themselves subjected to the credit channel in the euro area.     

Role of credit and monetary policy in determining asset prices: Evidence from emerging market economies

We examine the relative dominance of credit and monetary policy shocks in influencing asset prices in emerging markets. Estimates from panel VAR models for 22 EMEs provide evidence of a significant impact of bank credit on house prices in contrast to trivial impact on stock prices, possibly due to prudential regulations on banks’ exposure to stock markets. Contractionary monetary policy triggers sizeable and persistent decline in stock than housing prices as higher interest rates may render the funding of leverage costlier. Global shocks play an important role in explaining fluctuations in domestic stock prices rather than house prices since the latter class of asset is largely non-tradable across countries.     

Does money help predict inflation? An empirical assessment for Central Europe

This paper investigates the predictive ability of money for future inflation in the Czech Republic, Hungary, Poland and Slovakia. We construct monetary indicators similar to those the European Central Bank regularly uses for monetary analysis. We find in-sample evidence that money matters for future inflation at the policy horizons that central banks typically focus on, but our pseudo out-of-sample forecasting exercise shows that money does not in general improve the inflation forecasts vis-à-vis some benchmark models such as the autoregressive process. Since at least some models containing money improve the inflation forecasts in certain periods, we argue that money still serves as a useful cross-check for monetary policy analysis.     

Nonlinear effects of monetary policy on stock returns in a smooth transition autoregressive model

This paper employs smooth transition autoregressive (STAR) models to investigate the nonlinear effect of monetary policy on stock returns. The change in the Federal funds rate is used as an endogenous measure of monetary policy, and the growth rate of industrial production is also considered in the model. Our results show that the relationship between the monetary policy and excess returns on stock prices is positive and nonlinear. A decrease in the Federal funds rate causes a larger increase in excess returns if excess stock returns are located in the extreme low excess returns regime.     

Monetary policy on twitter and asset prices: Evidence from computational text analysis

In this paper, we dissect the Twitter debate about the future course of monetary policy and trace the effects of selected topics of this discourse on U.S. asset prices. We focus on the “taper tantrum” episode in 2013, a period with large revisions in expectations about future Fed policy. Based on a novel data set of 90,000 Twitter messages (“tweets”) covering the debate of Fed tapering on Twitter, we use Latent Dirichlet Allocation, a computational text analysis tool, to quantify the content of the discussion. Several estimated topic frequencies are then included in a VAR model to estimate the effects of topic shocks on asset prices. We find that the discussion about Fed policy on social media contains price-relevant information. Shocks to the discussion about the timing of the tapering, about the broader economic policy context and worrying investors are shown to lead to significant asset price changes. We also show that the effects are mostly due to changes in the term premium of yields consistent with the portfolio balance channel of unconventional monetary policy.     

Monetary policy and bank performance: The role of business models

This paper examines the relationship between monetary policy and bank performance in a multiple-instrument environment, particularly highlighting the conditioning role of bank business models. Employing a unique dataset of Vietnamese commercial banks from 2007 to 2019, we display that banks react to monetary policy changes, either when the central bank increases policy rates or injects money into the economy through open market operations, by decreasing overall returns and increasing financial instability. Additionally, we document that the accumulation of foreign exchange reserves benefits bank outcomes, contrasting to open market operations, albeit the central bank uses both of these policy instruments to alter money supply in the economy. Our key analysis of interest reveals that business models considerably matter in the effects of monetary policy on bank performance. Collectively, our findings demonstrate that banks’ business models that yield more non-interest income or diversify more into different income sources may mitigate the pass-through of monetary policy to bank performance. This finding holds across all interest- and quantitative-based monetary policy indicators and across all the functions of risk-taking behavior, earning-profit capacity, and financial stability. Furthermore, while plotting the marginal effects of monetary policy, we realize that they are insignificant for banks whose business models heavily rely on non-traditional segments.     

International spillovers in global asset markets

The paper empirically estimates the financial transmission within and across bond and equity markets in the four largest global financial markets – the United States, the Euro area, Japan, and the United Kingdom. We argue that international bond and equity markets are highly interconnected both within and across asset classes in a globalized world, where the complex transmission process across various financial assets is not restricted to just the domestic market. This paper employs identification through generalized forecast error variance decompositions to estimate spillovers across four systemic markets in a Vector Autoregression (VAR) framework. We find that asset prices react most strongly to international shocks within the same asset class, but that there are also substantial international spillovers across asset classes. Rolling estimations analysis provides evidence that global asset markets have become more integrated and that the bilateral relationships change over time. Our results are robust to specifications that take into account the monetary policy stance and include foreign exchange markets.     

News shocks and asset price volatility in general equilibrium

We study equity price volatility in general equilibrium with news shocks about future productivity and monetary policy. As West (1988) shows, in a partial equilibrium present discounted value model, news about the future cash flow reduces asset price volatility. We show that introducing news shocks in a canonical dynamic stochastic general equilibrium model may not reduce asset price volatility under plausible parameter assumptions. This is because, in general equilibrium, the asset cash flow itself may be affected by the introduction of news shocks. In addition, we show that neglecting to account for policy news shocks (e.g., policy announcements) can potentially bias empirical estimates of the impact of monetary policy shocks on asset prices.     

Energy prices and aggregate economic activity: an interpretative survey

In this article, we survey the theory and evidence linking fluctuations in energy prices to those in aggregate economic activity. We then examine the implications of this research for both monetary policy and energy policy in response to oil price shocks. The currently available research seems to provide relatively reliable guidance for monetary policy. Because the precise channels through which oil price shocks affect economic activity are only partially known, however, research offers less guidance about how countries should design energy policy should cope with oil price shocks.     

Asset price targeting in an open economy with cognitive limitations: The best for macroeconomic and financial stability?

The choices of policy targets and the formation of agent expectations have been critical issues addressed by monetary policy management since the financial crisis of 2008. This paper evaluates macroeconomic stability in a new Keynesian open economy in which agents experience both cognitive limitations and asset market volatility. The (im)perfect credibility of various monetary policies (e.g., a Taylor-type rule with- or without asset price targeting, strict domestic inflation targeting, strict CPI inflation targeting, and exchange rate peg) may lead agents to react according to their expectation rules, and thus create various degrees of booms and busts in output and inflation. Simulations confirm that a Taylor-type CPI inflation targeting including an asset price target is the best choice. In contrast, the business cycles induced by Keynesian “animal spirits” are enhanced by strict inflation targeting. Furthermore, a credible exchange rate pegging system with an international reserve pooling arrangement can improve social welfare and stability in an open economy, even though its absolute value of the loss function is slightly lower than a Taylor-type CPI inflation targeting including an asset price target.     

The response of asset prices to monetary policy shocks: Stronger than thought

Standard macroeconomic theory predicts rapid responses of asset prices to monetary policy shocks. Small‐scale vector autoregressions (VARs), however, often find sluggish and insignificant impact effects. Using the same high‐frequency instrument to identify monetary policy shocks, we show that a large‐scale dynamic factor model finds overall stronger and quicker asset price reactions compared to a benchmark VAR, both on euro area and US data. Our results suggest that incorporating a sufficiently large information set is crucial to estimate monetary policy effects.     

International spillovers of (un)conventional monetary policy: The effect of the ECB and the US Fed on non-euro EU countries

We estimate a global vector autoregression model to examine the effects of euro area and US monetary policy stances, together with the effect of euro area consumer prices, on economic activity and prices in non-euro EU countries using monthly data from 2001-2016. Along with some standard macroeconomic variables, our model contains measures of the shadow monetary policy rate to address the zero lower bound and the implementation of unconventional monetary policy by the European Central Bank and the US Federal Reserve. We find that these monetary shocks have the expected qualitative effects but their magnitude differs across countries, with southeastern EU economies being less affected than their peers in Central Europe. Euro area monetary shocks have a greater effect than those that emanate from the US. We also find certain evidence that the effects of unconventional monetary policy measures are weaker than those of conventional measures. The spillovers of euro area price shocks to non-euro EU countries are limited, suggesting that the law of one price materializes slowly.     

Does trade integration alter monetary policy transmission?

This paper explores the role of trade integration—or openness—for monetary policy transmission in a medium-scale new Keynesian model. Allowing for strategic complementarities in price setting, we highlight a new dimension of the exchange rate channel by which monetary policy directly impacts domestic inflation: a monetary contraction which appreciates the exchange rate lowers the local currency price of imported goods; this, in turn, induces domestic producers to lower their prices too. We pin down key parameters of the model by matching impulse responses obtained from a vector autoregression on time series for the US relative to the euro area. Our estimation procedure yields plausible parameter values and suggests a strong role for strategic complementarities. Counterfactual simulations show that openness alters monetary transmission significantly. While the contractionary effect of a monetary policy shock on inflation and output tends to increase in openness, we find that monetary policy's control over inflation increases, as the output decline which is necessary to bring about a given reduction of inflation is smaller in more open economies.     

Monetary policy rules for convergence to the Euro

This paper investigates the applicability of open-economy convergence-consistent instrument rules for monetary policies in the economies undergoing monetary convergence to a common currency area. The proposed policy rule is forward-looking, consistent with a monetary framework based on inflation-targeting containing input variables that are relative to the corresponding variables in the common currency area. Robust forms of the policy rule are tested empirically for three inflation-targeting countries converging to the euro, i.e. the Czech Republic, Poland and Hungary. Empirical tests imply systemic differences in monetary policies among these euro-candidates. The Czech monetary policy seemingly follows the rule prescribed by our model. Both the Czech and the Polish central bank interest rate policies respond predominantly to changes in the inflation gap, while the Hungarian responds mainly to the exchange rate gap. In all three cases, changes in the eurozone short-term interest rates strongly drive adjustments in the central banks’ reference interest rates.     

Monetary policy in open economies: Practical perspectives for pragmatic central bankers

This paper reviews and interprets some of the key policy implications that flow from a class of DSGE models for optimal monetary policy in the open economy. The framework suggests that good macroeconomic outcomes in open economies are possible by focusing inflation targeting that is implemented by a Taylor type rule, a rule that in equilibrium is reflected in the exchange rate as an asset price. Optimal monetary policy will not be able deliver a stationary (‘stable’) nominal exchange rate – let alone a fixed exchange rate or one that remains inside a target zone – because, absent a commitment device, optimal monetary can’t deliver a stationary domestic price level. Another feature in the data for inflation targeting countries that is consistent with monetary policy via Taylor type rule is that it will tend push the nominal exchange rate in the opposite direction from PPP in response to an ‘inflation’ shock—the ‘bad news god news’ result of Clarida and Waldman (2008. Is Bad News about Inflation Good News for the Exchange Rate. In: John Campbell, (Ed.), Asset Prices and Monetary Policy, Chicago: University of Chicago Press), Clarida and Waldman (2014. Bad News About Inflation is Good News for the Nominal Exchange Rate Under Optimal Monetary Policy: DSGE Theory and a Decade of Empirical Evidence). This is so even though in the long run of these models the nominal exchange rate must in expectation obey PPP.     

Monetary policy and stock prices in small open economies: Empirical evidence for the new EU member states

This study presents evidence on the effect of domestic and Euro Area monetary policy on stock prices in four new EU member states of Central Europe and the main determinants of stock price volatility, estimating structural vector autoregressive models identified with short-run restrictions. We find that stock prices in the considered new EU member states are more sensitive to changes in the Euro Area interest rate than to the domestic one. Moreover, the bulk of stock price volatility in these countries is due to shocks related to exchange rate and Euro Area monetary policy. Overall, we find that local stock markets are more sensitive to external shocks than to domestic ones.     

Monetary Policy and Macroprudential Policy: New Evidence from a World Panel of Countries

The event of the recent financial crisis raises the question of whether policy makers could have done more or something different to prevent the build‐up of financial imbalances. This paper contributes to the field of regulatory impact by tackling the debate on whether central banks should ‘lean against the wind’, while in case the response is positive, how macroprudential policies should be combined with monetary policy. Using an augmented Taylor rule and a sample of 127 global economies, the results provide evidence on the importance of macroprudential issues for the implementation of an effective monetary policy. They also document that the type of adopted macroprudential instrument has a substantial effect on such effectiveness, with this policy mix being less ‘integrated’ when the monetary rule aims at primarily safeguarding inflation stability. The results survive robustness checks under alternative assets.     

A survey on time-varying parameter Taylor rule: A model modified with interest rate pass-through

Today, the prime aim of central banking is to achieve price stability and, to a lesser extent, output stability. To this end, central banks use various monetary policy rules. This paper intends to provide a broad survey of the literature on Taylor-type monetary policy rules with a time-varying parameter (TVP) specification. To include the TVP feature, some modification is made in the monetary transmission mechanism of Taylor-type monetary policy models to account for the changing risk preference of individuals. In line with this approach, we introduce an interest rate pass-through specification of the monetary transmission process in a general equilibrium model to account for the varying perceptions of risk by individuals. We include an application for Turkey and estimate the time-variable parameters of the model by employing a structural extended Kalman filter (EKF). The results indicate that the EKF performs better than the standard Kalman filter in estimating the reaction function of the central bank.