To Believe or Not to Believe: Monetary Policy and the Trend in House Prices

Abstract

House prices are usually characterized by periods of long-lasting growth that lead to uncertainty concerning their persistence. This uncertainty is of special importance for central banks: the prolonged periods of rise followed by sudden fall in house prices are often associated with a credit crunch and a long-lasting and painful recession. Furthermore, monetary policy - incorrectly assessing the persistence of house prices - may further amplify the impact of house prices on the economy. In order to analyze the costs of this mistake I compare the performance of two policy rules that are optimal under extreme assumptions: 1. there is a housing shock that leads to the persistent deviations of house prices from the long-run trend and 2. there is no such a shock and house prices deviate from the trend only due to the impact of other shocks. I show that the central bank minimizing these costs should act as if house prices persistently deviate from the trend. If the central bank incorrectly assumes that house prices change only because of other shocks it conducts too loose monetary policy that significantly increases fluctuations of output gap and inflation.