Question

Why are interest rates ineffective in stabilising asset prices?

Answer 1

Interest rates responds to asset prices only over time if they are seen to diverge from the levels with which the central bank feels comfortable.

Figure shows the analyses the effects of a 100 basis points increase in interest rates. Note that after about 8 quarters, interest rates have declined but remain about 35 basis points above their initial level. After 12 quarters, they have fallen further to a level some 10 basis points above the starting point. Overall, the increase in interest rates will dissipate in about three years.

Turning to real property prices, we note that these start to fall in response to the tightening of interest rates . After 16 quarters, they reach a bottom of about 2.6% below the initial level and then start to return gradually to their starting level. Overall, property prices react quite slowly to interest rates actions.

* Interest rates ineffective in stabilising asset prices becuase -

Research suggests that in practice, monetary policy is too blunt an instrument to be used to target asset prices – the effects on real property prices are too small, given the responses of real GDP, and they are too slow, given the responses of real equity prices. In particular, there is a risk that setting monetary policy in response to asset price movements will lead to large output losses that exceed by a wide margin those that would arise from a possible bubble burst.