How do central banks react to wealth composition and asset prices?

Abstract

We assess the response of monetary policy to developments in asset markets in the euro area, the US and the UK. We estimate the reaction of monetary policy towealthcompositionandasset prices using: (i) a linear framework based on a fully simultaneous system approach in a Bayesian environment; and (ii) a nonlinear specification that relies on a smooth transition regression model.

The linear framework suggests that wealthcomposition is indeed important in the formulation of monetary policy. However, the attempts of centralbanksto mitigate undesirable fluctuations in say, financial wealth, may disrupt housing wealth. A similar result can be found when we look at the reaction of monetary authority toasset prices, although "price" effects" seem to play a weaker role.

The nonlinear model confirms these findings. However, the concerns over wealthand its components are stronger once inflation is under control, i.e. below a certain target. Some disruptions between financial and housing wealth effects are still present. They can also be found in the reaction toasset prices, despite being less intense.