Incorporating asset price stability in the European Central Bank's inflation targeting framework

Abstract

AbstractWe propose a new flexible inflation targeting index, the economic stability index (ESI), that could enable the European Central Bank (ECB) to implement more effective monetary policy for the euro area (EA). This index incorporates separately weighed house prices and stock prices. Furthermore, by weighting the housing sector in both normal and bubble events, it enhances the forecasting ability and accuracy of this new index. We demonstrate the resilience of this index using a range of robustness checks with multiple empirical methods. Our index that is equipped with these forward‐looking variables enhances the ability to sense potential economic risks, whilst improving price stability and minimizing the output gap variance. This broader index may assist the ECB in addressing the challenges of the long‐term decline of neutral interest rates in many EA economies and the weakening of the inflation/unemployment relationship under the Philips curve. The complexity of the ECB relationship with different fiscal authorities prevents any changes without significant structural variance. The ECB, however, can use a stabilization tool with enhanced foreseeability such as this ESI to improve stability without making significant structural changes.