In recent decades, asset booms and busts have been important factors in macroeconomic fluctuations in both industrial and developing countries. In light of this experience, how, if at all, should central bankers respond to asset price volatility? We have addressed this issue in previous work (Bernanke and Gertler, 1999). The context of our earlier study was the relatively new, but increasingly popular, monetary-policy framework known as inflation-targeting (see e.g., Bernanke and Frederic Mishkin, 1997). In an inflation-targeting framework, publicly announced medium-term inflation targets provide a nominal anchor for monetary policy, while allowing the central bank some flexibility to help stabilize the real economy in the short run. The inflation-targeting approach gives a specific answer to the question of how central bankers should respond to asset prices: Changes in asset prices should affect monetary policy only to the extent that they affect the central bank’s forecast of inflation. To a first approximation, once the predictive content of asset prices for inflation has been accounted for, there should be no additional response of monetary policy to assetprice fluctuations. In use now for about a decade, inflationtargeting has generally performed well in practice. However, so far this approach has not often been stress-tested by large swings in asset prices. Our earlier research employed simulations of a small, calibrated macroeconomic model to examine how an inflation-targeting policy (defined as one in which the central bank’s instrument interest rate responds primarily to changes in expected inflation) might fare in the face of a boom-and-bust cycle in asset prices. We found that an aggressive inflationtargeting policy rule (in our simulations, one in which the coefficient relating the instrument interest rate to expected inflation is 2.0) substantially stabilizes both output and inflation in scenarios in which a bubble in stock prices develops and then collapses, as well as in scenarios in which technology shocks drive stock prices. Intuitively, inflation-targeting central banks automatically accommodate productivity gains that lift stock prices, while offsetting purely speculative increases or decreases in stock values whose primary effects are through aggregate demand. Conditional on a strong policy response to expected inflation, we found little if any additional gains from allowing an independent response of central-bank policy to the level of asset prices. In our view, there are good reasons, outside of our formal model, to worry about attempts by central banks to influence asset prices, including the fact that (as history has shown) the effects of such attempts on market psychology are dangerously unpredictable. Hence, we concluded that inflationtargeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast. In the spirit of recent work on robust control, the exercises in our earlier paper analyzed the performance of policy rules in worst-case † Discussants: Robert Shiller, Yale University; Glenn Rudebusch, Federal Reserve Bank of San Francisco; Kenneth Rogoff, Harvard University.

Can monetary policy committees, accustomed to describing their plans and actions in terms of the level of a short-term nominal interest rate, find effective means of conducting and communicating their policies when that rate is zero or close to zero? The very low levels of interest rates in Japan, Switzerland, and the United States in recent years have stimulated much interesting research on this question and have led some central banks to make changes in their operating procedures and communications strategies. In this paper, we will give a brief overview of current thinking on the conduct of monetary policy when short-term interest rates are very low or even zero. Monetary policy works for the most part by influencing the prices and yields of financial assets, which in turn affect economic decisions and thus the evolution of the economy. When the short-term policy rate is at or near zero, the conventional means of effecting monetary ease (lowering the target for the policy rate) is no longer feasible. However, it would be a mistake to think that monetary policy was impotent. We discuss three strategies for stimulating the economy at an unchanged level of the policy rate: these involve (i) providing assurance to investors that short rates will be kept lower in the future than they currently expect, (ii) changing the relative supplies of securities in the marketplace by altering the composition of the central bank’s balance sheet, and (iii) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”). We also discuss the costs and benefits of very low interest rates, an issue that bears on the question of whether the central bank should take the policy rate all the way to zero before undertaking alternative policies.

We show that the interest rate on Federal funds is extremely informative about future movements of real macroeconomic variables. Then we argue that the reason for this forecasting success is that the funds rate sensitively records shocks to the supply of bank reserves; that is, the funds rate is a good indicator of monetary policy actions. Finally, using innovations to the funds rate as a measure of changes in policy, we present evidence consistent with the view that monetary policy works at least in part through "credit" (i.e., bank loans) as well as through "money" (i.e., bank deposits).