Monetary Policy And Asset Prices Linkages

A number of theories exist that explain the link between monetary policy and asset prices. In general, there is no theoretical consensus, in terms of direction of causality between monetary policy and asset prices; regarding reactions of monetary policy to asset price volatility or approaches of analyzing the linkages between the two issues. Some studies support the notion that price stability guarantees financial system stability. Claudio and Lowe (2002) have summarized some of these works and have noted that various arguments in the literature contend that a monetary regime that produces aggregate price stability will as a by-product tend to promote the stability of the financial system. According to this line of reasoning, an unexpected decrease in inflation increases the real value of outstanding debt and makes defaults more likely while an increase in inflation leads to increases in acquisitions of leveraged assets thus leading to misallocation of resources that may also create vulnerability in the financial system. This implies that there are synergies between monetary policy and financial stability. Therefore, credibly maintained prices provide an environment of predictable interest rates implying low risk of interest rate mismatches, reduction in inflation premium in long-term interest rate thus contributing to financial soundness.

Similar studies have transcended the synergies between monetary policy and the financial system by pointing out that it is also possible for trade-offs between financial stability and monetary policy to be experienced. Garcia and Pedro (2003) provide a good summary of these studies, where, on the one hand, it is shown that high levels of interest meant to control inflation negatively affect bank’s balance sheet and firm’s net financial worth especially if they attract capital inflows. In turn capital inflows contribute to over borrowing, increased credit risk and currency mismatches if foreign capital flows are converted into domestic currency denominated loans. Inflation control may require fast and substantial increase in interest rate, which banks cannot pass as quickly to their assets compared to their liabilities leading to increase in interest rate mismatches and market risk.

Some authors, notably, Claudio and Lowe (2002) argue that inflationary pressures first become evident in asset markets rather than goods markets. According to these authors, it is not the unanticipated changes in goods and services price inflation that create financial problems, rather it is changes in asset prices and the unwinding of financial imbalances build up in previous years that create instability. This is particularly evident if there is improvement in the supply side of the economy that creates optimism where demand pressure on goods inflation may be masked while the increase in asset prices continues. Moreover, in a credible monetary policy environment where inflation expectations are well anchored with long-term price and wage contracting, the goods and services inflation rate may be less sensitive at least for a period of time to any demand pressures in the economy. This stickiness in costs and prices can boost profits, particularly if firms are operating with excess capacity or under increasing returns to scale, given a credible monetary policy associated with reduced uncertainty. Consequently, the resulting higher asset prices coupled with increased willingness to borrow make financial systems more vulnerable to economic downturn. Monetary authorities find little reason to tighten monetary policy with low inflation and high credibility if they respond only to clear signs of inflationary pressure, thus increasing the probability that latent inflation pressures manifest themselves in the development of imbalances in the financial system, rather than immediate upward pressure on prices of goods and services.

Other studies have focused on the monetary policy transmission mechanisms and the role of asset prices, in which case the nexus between financial stability and monetary policy is traced from the volatility in the stock market. According to these studies, monetary policy actions do not only affect the economy through interest rates but other asset prices. This literature categorizes the transmission mechanisms involving the stock market into three types including the Tobin q effects, firm balance sheet effect and household liquidity effects.

According to the Tobin q framework, if q, which is defined as the market value of firms to the replacement cost of capital, is high, then the market price of firms is high relative to the replacement cost and new plant and equipment capital is cheap relative to the market value of firms. In this case companies can issue stock and get a high price for it relative to the cost of facilities and equipment they are buying which increases their investment. Under this framework an expansionary monetary policy would make bonds less lucrative compared to stocks leading to increased demand for stocks. High demand would in turn lead to increased price of stocks, increased q and increased investment, aggregate demand and hence increased inflationary effects. Besides increased stock prices imply reduced cost of capital since, it is now cheaper for firms to finance their investment since each share issued produces more funds. According to the balance sheet effect approach it is shown that expansionary monetary policy increases the prices of stocks leading to increases in the net worth of firms, which results in lower adverse selection and moral hazard. This leads to increases in lending, which stimulate investments and aggregate demand. The balance sheet effects also work through household liquidity effects where increases in prices of stocks triggered by expansionary monetary policy leads to increases in the value of financial assets or wealth (likelihood of reduced financial distress), which in turns leads to, increases in consumer expenditure and residential housing spending. This is equivalent to deriving monetary policy through asset prices from the Modigliani life cycle model.

In analyzing the linkage between stock markets and monetary policy, Lkhagvajav et al. (2008) identified three factors that affect stock prices. First, the news that current or future dividends will be higher could raise stock prices. Second, news that current or future real short-term interest rates will be higher could lower stock prices and third, news that leads investors to a higher risk premium on stocks could lower stock prices. Higher interest rates make a given future dividend less valuable in today’s dollars; higher interest rate reduces the value of a share of stock. In addition, higher interest rates make investments other than stocks such as bonds more attractive, raising the required return on stocks and reducing what investors are willing to pay for them. According to this study, central bank’s actions should affect stock prices only to the extent that they affect investor expectations about dividends, short-term real interest rates or the riskiness of stocks. Other arguments in the same line of reasoning, notably by Kyriacos et al. (2006) contend that inflation is predominantly responsible for the high equity premium observed over time for a number of some industrialized countries. According to these authors, inflation adds approximately between 2 and 4 percent of the realized equity premiums. This impact of inflation comes from the relative poor performance of bonds during inflationary periods. Disagreements also exist in terms of monetary policy response to instability in the financial system. The debate on whether the central should prick, target, take an interest or ignore asset price bubbles is still raging. Prasad (2010) support the idea that central banks should track asset prices arguing that asset prices are often subject to bubbles and crashes. This may have strong pro-cyclical effects and may also affect the stability of financial markets. Since central banks are responsible for financial stability they should monitor asset prices and try to prevent the emergence of bubbles (that invariably lead to crashes). According to this view, the use of the interest rate is seen as effective in preventing bubbles from emerging. Moreover, as pointed by Kontonikas and Montagnoli (2006), the financial-market channel plays an important role in the transmission of monetary policy. Thus, in the presence of wealth effects and inefficient markets, asset price misalignments from their fundamentals should be included in the optimal interest rate reaction function. It should however be noted that few economists from this school could argue that the central bank should target a particular value of the asset price (in the same way as it targets an inflation rate). Instead a majority of the proponents of this school of thought argue that a strategy of “leaning against the wind” may be useful to reduce too strong movements in asset prices.

Some authors such as Gregorio (2010) counter-argue that monetary tightening is a highly inefficient tool to prick a bubble, and cites several instances where this has failed. According to this contention, given the well-established fact that central banks today directly influence only a small portion of capital markets with their open market operations (OMO) and setting of short-term interest rates, and that the primary means of transmitting monetary policy is through expectations, it is difficult to see why there should be a mechanical connection between tighter monetary conditions and investor behavior. If investors truly believe that there is money to be made in a bubble, and usually are counting on making large amounts of money (which is why it is a bubble in the first place), it seems strange to think that a marginal rise in interest rates would be sufficient to alter their actions. If the central bank were truly the only source of liquidity in town, cutting investors off when they have too much credit or are deemed to be taking on too much risk might be effective. But central banks together with the commercial banks they extend credit to, are not the only sources of liquidity available to investors. In this line of argument, the impact of bubbles on the macro economy has something to do with financial supervision and regulation than with monetary policy (Posen, 2006).Other authors, notably, Lagos (2010) examined the asset price-monetary policy linkage based on a dynamic equilibrium micro founded monetary asset pricing framework. According to this author, money coexists with equity shares on a risky aggregate endowment. Agents may therefore use equity as a means of payment, so shocks to equity prices translate into aggregate liquidity shocks that disrupt the mechanisms of exchange and ensuing allocations in some key markets and through this channel propagate to the macro economy. The findings of this study indicate that persistent deviations from an optimal monetary policy may cause the real price of assets that could be used to relax the trading constraints to exhibit persistent deviation from their fundamental values.