Monetary Policy, Asset Prices and Misspecification The robust approach to bubbles with model uncertainty

The period from 1995:Q1 to 2000:Q2 was an unusual one for the U.S. economy. Labor productivity growth, which had averaged 1-1/4 percent per year over the previous 20 years, nearly doubled. Over the same boom period, the federal funds rate was remarkably stable--perhaps in response to core inflation rates that mostly fell. From 1952 to 1994, stock-market capitalization fluctuated between 30 and 100 percent of nominal GDP. From there, it rocketed to a peak of 185 percent of GDP in 2000:Q1. Over the past two years, however, the stock market has retraced a significant portion of its previous gains, the economy has slid into recession and the subsequent recovery has been a halting one. The question arises as to the role of the apparent stock-market bubble in bringing about the recession and whether there was more that the Fed could have done to forestall that outcome. Bernanke and Gertler (1999) argue the laissez-faire view that the quiescence of monetary policy was the correct response, that monetary policy should respond only to the projected effects of stock-market movements on inflation and perhaps output, but not to perceived stock-market bubbles per se. Cecchetti et al. (2000) disagree, advancing the interventionist view that, in the words of Mussa (2002) central banks “can, should and do” respond (directly) to bubbles. Both Bernanke and Gertler (1999) and Cecchetti et al. (2000) rely primarily on ad hoc augmentations of Taylor-type policy rules to examine model properties in response to shocks that are carefully constructed to isolate bubble phenomena. This obliges them to only loosely infer the implications of being wrong about the existence, nature, persistence and implications of a bubble. In this paper, we use a variant of the Bernanke-Gertler-Gilchrist model to reassess the case for responding to bubbles. The paper makes three contributions. First, we embellish the BGG model to see if the optimistic conclusion offered by BG is sensitive to changes in specification. Second, we add a bit more rigor regarding what is an optimal policy given the beliefs of the monetary authority. And third, we consider robust responses by the policy maker to uncertainty about aspects of the bubble process. Monetary Policy, Asset Prices and Misspecification 2