Should Central Banks Lean Against Changes in Asset Prices?

How should monetary policy be conducted in the presence of endogenous feedback loops between asset prices, firms’ financial health, and economic activity? We reconsider this question in the context of the financial accelerator model and show that, when the level of natural output is inefficient, the optimal monetary policy under commitment leans considerably against movements in asset prices and risk premia. We demonstrate that an endogenous feedback loop is crucial for this result and that price stability is otherwise quasi-optimal absent this feature. We also show that the optimal policy can be closely approximated and implemented using a speed-limit rule that places a substantial weight on the growth of financial variables. ∗The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Swiss National Bank, the Federal Reserve Bank of San Francisco or any other person associated with the Federal Reserve System. †Federal Reserve Bank of San Francisco. Corresponding Author: Sylvain Leduc, Telephone 415-974-3059, Fax 415-974-2168. Email address: [email protected] ‡Swiss National bank. Email address: [email protected] 1