1. Asset Price Bubbles and Monetary Policy: A Multivariate Extension By Andrew Filardo, BIS Prepared for a workshop on “Fundamental and Non-fundamental Asset Price Dynamics: Where Do We Stand?”, Venastul, Norway, 14-15 February 2008

2. General Motivation Greenspan, Bubbles and Policy “In conclusion, the endeavors of policy makers to stabilize our economies require a functioning model of the way our economies work. Increasingly, it appears that this model needs to embody movements in equity premiums and the development of bubbles if it is to explain history.” Jackson Hole 2002

3. Key Contributions Of This Paper  Methodology – relatively simple macro setup and “realistic” multivariate bubble specification do work and yield key insights  Modelling – endogenous multivariate bubbles in a dynamic macro model  Monetary policy – conventional wisdom about ‘benign neglect and mopping-up later approach’ may be too optimistic in the current policy environment

4. Preview Of Findings  Multivariate bubble considerations complicate the policy tradeoffs:  It is optimal to respond to asset prices generally and bubbles specifically! Defensive strategies – preventing and pricking asset price bubbles Opportunistic strategies – use bubbles to achieve stabilization goals

5. Monetary Policy And Asset Prices  Asset price booms and busts have been extreme developments that monetary authorities have had to face.

6. Monetary Policy and Asset Prices Housing Equity Housing

7. Monetary Policy and Asset Prices: Asia-Pacific Equity Housing

8. Monetary Policy an Asset Prices  Asset price booms and busts are an important feature of the monetary policy landscape going forward. [Borio, English and Filardo (2003)]  The double-bubble aspect of this relationship has been underappreciated  Asset price booms and busts have been extreme developments that monetary authorities have had to face.

9. Road Map  Lay out monetary policy model  Multivariate bubble specification  Results  Policy implications and conclusions

10. The Greenspan Approach – Conventional Wisdom? “ …Greenspan’s preferred approach to bubbles is to let them burst of their own accord, and then to use monetary policy (and other instruments), as necessary, to protect the banking system and the economy from the fallout…the ‘mop-up after’ strategy “If the mopping up strategy worked this well after the mega-bubble burst in 2000, shouldn’t we assume that it will also work after other, presumably smaller, bubbles burst in the future?” Blinder & Reis, Jackson Hole 2006

11. Three Modelling Blocks Small-Scale Macro Model

12. Asset Price Block

13. Monetary Policy Block Standard Loss Function

14. Optimal Monetary Policy subject to the model of the macroeconomy and asset prices:

15. 3 Policy Specifications

16. Modelling the Bubble Time-Varying Transition Probability (TVTP) Model For Each Bubble

17. Modelling the Bubble Time-Varying Transition Probability Model Sample Path of a Bubble - “Blowing Bubbles” -20 -15 -10 -5 0 5 10 15 1234567891011121314151617181920 Time periods

18. Modelling the Bubble No-Bubble State Transition Probability Function of y t-1

19. Modelling the Bubble Bubble State Transition Probability  2 specifications - weakly interacting multivariate bubbles - strongly interacting multivariate bubbles ‘Own’ duration dependence for strong version Housing bubble transition probability

20. Results for Optimal Policy Variance of inflation Variance of output Optimal Monetary Policy Frontiers

21. Results for Optimal Policy Variance of inflation Variance of output Optimal Monetary Policy Frontiers Superior policy

22. Results for Optimal Policy Variance of inflation Variance of output Optimal Monetary Policy Frontiers

23. Result for Standard Taylor Rule Optimal Policy Frontiers No response to AP

24. Basic Result I: Pricking AP Is Optimal Optimal Policy Frontiers No response to AP Response to AP

25. Basic Result 2: Knowing NF and F not critical Optimal Policy Frontiers No response to AP Response to AP Response to F and NF

26. A Little Bit of Nonlinearity, Important Consequences Bubble part

27. Complex Dynamics in Model Output

28. Nonlinear Impulse Responses Inflation

29. Nonlinear Impulse Responses Illustrate…  Endogenous bubble models admit richer dynamics  Chaotic behavior is possible  Monetary policy helps to stabilize the economy… … by not only pricking bubbles but also by exploiting bubbles (Blanchard, 2000)

30. Expected Durations  How do the expected durations of a bubble change over time? - Assume in the no-bubble steady state and a pickup in economic activity begins - In simulations, an 8-period positive shock to y

31. Expected Durations – Monetary Policy Matters!

32. Expected Duration for Housing Bubble

33. Start with an equity bubble (1995) Then a housing bubble begins (1999) Then recessionary shocks start (2000) & soon after the equity price bubble collapses Subpar growth shocks end (2002) Equity price bubble restarts (2003) Counterfactual simulation (?)

34. Expected Duration for Housing Bubble Recession ends at point D and optimal R increases! E bubble H bubble Recession

35. Expected Duration for Housing Bubble Too Low, Too Long Policy

36. Summary – So Far Optimal policy indicates central banks should respond to asset price bubbles on the way up as on the way down  in other words, no Greenspan benign neglect on the upside Also, double bubbles are a double whammy on Greenspan approach  don’t be too aggressive on the downside Consensus view a la Blinder/Reis not robust!

37. Extra Consideration – Closer to Reality: Incorporating Uncertainty Into Analysis Compare the expected gains and losses from reacting to asset prices – Risk Management!

38. Bayesian Expected Loss Analysis

39. Implications for Monetary Policy and Benign Neglect Threshold Degree of confidence in bubble matters!

40. Conclusions In this class of models, generally monetary authorities want to respond to asset prices; it also optimal to “prevent and prick them.” Findings about optimal monetary policy in multi- bubble environment: - Intuition from single-bubble models might be misleading at this policy juncture - Greenspan approach in 2000+ may not be as attractive in 2008+

41. Conclusions What’s next on policy modelling front? - Forward-looking behavior (lengthening horizon!) - Uncertainty with small probability events (tail risk, insurance motives and ‘Greenspan/Bernanke put’) - Optimal policy mix especially at the ZLB

42. Conclusions What’s next on bubble modelling front? Better micro-foundations for financial imbalances and bubbles - What is the role of money and credit? - What is the nature of the coordination failure? - What is the role of rational herding and information cascades? Other behavioral models of asset prices?

43. So, here’s an alternative explanation for why the timing and size of the 75 basis point intermeeting cut in the federal funds rate target. Chairman Bernanke and his colleagues want us to know that when they see changes in the economy that compromise their medium-term stabilization objectives, they will act. January 23, ??? Where do we stand?... Now, In Disarray Investors expect the federal funds rate to be as low as 2.25% by the end of the year...In trying to prevent financial-market calamity, the (Bernanke) Fed may find itself pushed by Wall Street to leave interest rates too low for too long. The Economist, 31 January 2008

44. Thank you