Inflation Targeting, Asset Prices and Financial Imbalances: Conceptualizing the Debate

Abstract

This paper attempts to conceptualize the debate regarding the role of asset prices and perceived financial imbalances in the formation of monetary policy from the perspective of theoretically optimal policy responses. While much of the disagreement can be reconciled within the framework of flexible inflation targeting, defined as a commitment to a targeting rule, preemptive policy actions against the build-up of financial imbalances cannot be motivated within such a framework without modification either to the targeting rule or the underlying model. Given standard forecasting models, such actions are shown to be operationally equivalent to targeting financial imbalances explicitly in the central bank loss function.