Over the 1995-2004 period, the evolution of stock market indices in the United States and Europe exhibited a distinct boom-and-bust pattern, rising dramatically during the second half of the 1990s and falling sharply at the turn of the century. These changes in asset prices affected household wealth and the financing cost of investments, so that the period of rising asset prices was also characterised by strong economic growth, while the period of falling asset prices saw weaker growth. As equity markets were largely driven by “irrational exuberance” in the second half of the 1990s, it is sometimes argued that, in order to foster a more balanced growth path, the monetary authorities in the United States and the euro area should have targeted changes in a price index which not only includes contemporaneous consumer prices but also asset prices.
In this Working Paper we assess the worldwide macroeconomic implications of an interest rate rule whereby the major central banks of the world target not only changes in the traditional consumer price index but also changes in asset prices. We do this by simulating the nime model over the 1995-2004 period with an interest rate rule similar to the well-known Taylor rule, but augmented for changes in asset prices.
The paper is organized as follows. First, we give a quick overview of the major macroeconomic developments in the euro area, the United States and Japan over the 1995-2004 period, highlighting that changes in asset prices were not a major concern of the monetary authorities as they set the short-term interest rates. Next, starting form a broad price index and a functional form similar to the traditional Taylor rule, we specify an interest rate rule whereby monetary authorities target not only consumer price inflation and the output gap, but also changes in asset prices and changes in the output gap. Finally, we use the global macroeconometric nime model to calculate how the macroeconomic variables of the major economic areas would have behaved over the 1995-2004 period, had the monetary authorities of these areas implemented such a broad-based interest rate rule.
The results of the counterfactual simulation can be summarised as follows. Had the interest rate rule proposed in this Working Paper been adopted by the major central banks over the 1995-2004 period, interest rates in Europe and the United States would most likely have come out above their historical baseline for most of the 1995-2000 period. For example, the us short-term interest rate would have been 1.4 percentage-points above its historical baseline in 1999, while the short-term interest rate of the euro area would have come out 0.9 percentage-point above its baseline in 2000. The rate hikes in the euro area and the United States would have lowered these areas’ domestic demand by increasing the cost of investment and lowering household wealth. However, as the rate hikes would have been highest in the United States, the us dollar would have appreciated against other major currencies, thereby restraining us export growth but stimulating export growth from Europe and, especially, from Japan. After 2000, the implementation of this alternative interest rate rule would most likely have led to a fall in interest rates relative to their historical baseline in the euro area and the United States; over this period, domestic demand in these areas would have come out above their historical baseline level. Once again, the effect of the interest rate cuts on exchange rates is not straightforward, as all areas except Japan would have made important rate cuts. In Japan such cuts would not have been possible, due to the fact that the Japanese zero interest rate policy and the policy of quantitative easing had already brought nominal interest rates down to their lower bound.
The counterfactual simulation indicates that a broad-based interest rate rule would have pushed the euro area’s gdp above its historical level by about 0.3 per cent by the end of the 1995-2004 period and would have reduced us gdp by about 0.6 per cent by the end of the same period. Japanese gdp would have come out 1.3 per cent above its historical baseline level by the end of the 1995-2004 period, mainly due to strong gains in exports resulting from the weakening of the yen in the wake of the rising foreign interest rates. Nevertheless, implementing the alternative interest rate rule would have reduced output volatility somewhat.
Finally, as a caveat, it should be noted that although the new interest rate rule lowers output variability, the rule we implement is based on target values obtained through a filtering process applied to a historical outcome. In real-time however, defining targets for asset prices may not be straightforward and be surrounded by great uncertainty.