Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule

This paper estimates standard and extended Taylor rules for core countries in the euro area, namely France, Germany and Italy, as well as for the ECB. We perform extensive tests for over-identifying restrictions and instrument relevance, a practice generally eschewed in previous work. We find that asset prices can be highly relevant as instruments rather than as separate arguments in policy rules. Forecast-based rules perform best using the root mean squared error metric but produce coefficients implying that central banks may be too aggressive at fighting inflation.