DP12937 Leaning Against Housing Prices as Robustly Optimal Monetary Policy

Author(s): Klaus Adam, Michael Woodford
Publication Date: May 2018
Keyword(s): Asset price bubbles, Inflation targeting, leaning against the wind, optimal target criterion
JEL(s): D81, D84, E52
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12937

We analytically characterize optimal monetary policy for a New Keynesian model with a housing sector. If one supposes that the private sector has rational expectations about future housing prices and inflation, optimal monetary policy can be characterized without making reference to housing price developments: commitment to a "target criterion" that refers only to inflation and the output gap is optimal, as in the standard model without a housing sector. But when a policymaker seeks to choose a policy that is robust to potential departures of private sector expectations from model-consistent ones, then the optimal target criterion must also depend on housing prices. In the empirically realistic case where housing is subsidized and where monopoly power causes output to fall short of its optimal level, the robustly optimal target criterion requires the central bank to "lean against" housing prices: following unexpected housing price increases, policy should adopt a stance that is projected to undershoot its normal targets for inflation and the output gap, and similarly aim to overshoot those targets in the case of unexpected declines in housing prices. The robustly optimal target criterion does not require that policy distinguish between "fundamental" and "non-fundamental" movements in housing prices.