Asset Prices, Financial Stability, and Monetary Policy: Based on Japan's Experience of the Asset Price Bubble (Marrying the macro- and micro-prudential dimensions of financial stability, BIS Papers No. 1, Bank for International Settlement, March 2001) PDF File
Worldwide consensus has been established about the importance of central banks' independence and accountability in achieving price stability. However, concerning the role of central banks in prudential policy, a global standard has yet to be formed. In order to connect the two objectives, i.e., price stability and financial stability, in a mutually complementary manner, this paper focuses on the implications of asset price fluctuations for the stability of financial and economic environments. To this end, it is important to identify whether asset price fluctuations properly reflect movements in their underlying determinants, or fundamentals. This is because the misalignment of asset prices, i.e., an asset price bubble, produces serious adverse effects on the financial system and on the economy when the bubble eventually bursts. Moreover, the effect of asset price changes is asymmetric, with stronger effects in the case of an asset price decline, because the collapse in asset prices has adverse effects on the stability of the financial system. Monetary policy is required to respond to the potential risk of future asset price bubbles in a preemptive manner, based on an accurate analysis on the reasons behind the movement of asset prices. In so doing, the central bank should aim at 'sustainable price stability' that supports medium to long-term sustainable growth, not 'measured price stability' that merely maintains a specific rate of inflation measured by a specific price index at a particular point in time. Even if measured inflation is stable, a central bank needs to alter interest rates promptly once it judges that the risk of damaging 'sustainable price stability' has increased. By pursuing 'sustainable price stability,' the two objectives of central banks can be considered as complementary in the sense that one is a precondition for achieving the other. The existence of a conflict between these two objectives implies the necessity of coordination between the monetary and prudential policy functions of central banks as well as between central banks and financial supervisory and regulatory authorities.
Key words: Asset price bubble; Sustainable price stability; Stability of financial system; Monetary policy; Prudential policy