Was Bernanke right? Targeting asset prices may not be a good Idea after all

Should the central bank prevent excessive asset price dynamics or should it wait until the boom spontaneously turns into a crash and intervene only afterwards? The debate over this issue goes back at least to the exchange between Bernanke-Gertler (BG) and Cecchetti but has not settled yet. In their 1999 paper BG claimed that price stability and financial stability are highly complementary and mutually consistent objectives in a flexible inflation targeting regime which - dictates that central banks ... should not respond to changes in asset prices, except insofar as they signal changes in expected inflation. - (BG, 1999, p.18). This conclusion is straightforward within the variant of the NK-DSGE framework used by BG in which asset inflation shows up as a factor augmenting the IS curve. In the present paper, we pursue a different modelling strategy so that, in the end, asset price dynamics will be incorporated into the NK Phillips curve. In our context it is not true anymore that by focusing on inflation the central bank is also checking an asset price boom. We put ourselves, therefore, in the best position to obtain a significant stabilizing role for asset price targeting. It turns out, however, that inflation volatility is higher in the asset price targeting case. After all, therefore, targeting asset prices may not be a good idea.