Comments on “Optimal Monetary Policy in an Environment of Low Inflation

Periodically, some group of asset prices rises at a rapid pace that is matched neither by general price inflation nor seemingly by the relevant fundamental asset values. This situation rightfully causes great consternation at central banks, as it has dangerous implications for the stability of inflation and full employment and for financial stability. Some asset prices, such as those for housing, may directly affect general price inflation. Accelerating asset prices may also raise consumption through wealth effects and raise investment, say, due to the signal that rising equity prices sends firms. Together these can push output above potential, prompting instability in both employment and inflation. Finally, the accelerating growth in asset prices is sometimes rapidly reversed, posing threats to financial stability, full employment, and stable prices. Possible asset price bubbles give sleepless nights to central bankers. Takatoshi Ito, in his paper “Optimal Monetary Policy in an Environment of Low Inflation and Rising Asset Prices,” has provided an excellent discussion of the vast array of theoretical and empirical issues surrounding asset price bubbles and monetary policy. I agree with most all of the analysis in the paper and with the main conclusions. The main thrust of Ito’s advice is to temper the temptation of central bankers to respond aggressively to possible bubbles. As Ito argues, the central bank should be more reticent to react if, i) the central bank is less certain about whether or not there is, in fact, a bubble, ii) the central bank is less certain whether or not policy action would be beneficial, and iii) the central bank is more certain that the bubble-related costs would be modest. In my view, this is excellent advice. My main concern about Professor Ito’s interesting paper, and about much of the related literature, is that all the cogent analysis may leave the impression that economists understand a great deal about bubbles--enough to contemplate “optimal” policy in response to bubbles. In my view, our understanding of bubbles is still quite primitive, and this has important implications for how policymakers should respond. In these comments, I attempt to distill from Prof. Ito’s paper and the rest of the literature what