A Tale of Two Inflation Rates: House-Price Inflation and Monetary Policy

Abstract:

Price stability should be the ultimate goal of monetary policy, but which of many money prices should a central bank stabilize? A common argument is that the consumer price index should be stabilized because goods prices are sticky, with this being the key friction that monetary policy should mitigate. This paper presents a heterogeneous-agent, incomplete-markets model where households buy and sell houses over their lifetimes with purchases financed by nominal mortgage debt. The model includes aggregate risk from productivity shocks as well as financial shocks to borrowing constraints. The model generates a “financial cycle” where shocks that affect nominal house prices have real effects on balance sheets and lending, which feeds back into house prices. As a consequence, house-price fluctuations have implications for consumption volatility, as well as production. In this context, it is argued that the price stability central banks should seek is stability of nominal house prices. Achieving this improves risk sharing, promotes productive efficiency, and avoids bubbles. Moreover, by considering an additional “macroprudential” policy instrument, it is shown that interest-rate policy outperforms macroprudential policy in addressing financial stability concerns.