A new Taylor rule with asset inflation as a guide?

The Taylor rule has been a good model to describe the past behavior of the Fed and is also a good model for potentially setting the Fed funds rate to meet the dual goals of controlling inflation and maintain growth. Unfortunately, this rule is going to have to be adjusted under the new environment of zero interest rates. There can be some allowances for the new environment but a bigger concern is the fact that the Fed was unable to see or act on the bubble in financial markets.

There is a strong argument to be made that it is extremely difficult to see a bubble while it is occurring although the evidence is mounting that we had all of the information needed to tell us that the housing market was out of control. What some would argue is that we could have an adjusted Taylor rule which accounts for asset price inflation which could help with the targeting of interest rates. The argument for looking at financial asset prices is twofold. First, the wealth effect is significant. The changes in wealth are very important to a developed economy that is less reliant on industrial production and more levered. Second, is the fact that assets price increases could represent a form of inflation not captured in the CPI. There is asset inflation as well as goods inflation. To look at only one part does not make a lot of sense. We could have low price inflation while seeing “inflated” asset prices.

A direct examination of financial prices is very relevant for central bankers. In this case, the spread on corporate bond may be one measure of asset price inflation. Tight spreads would tell central bankers that the market is forcing down premia or inflating the price of risky assets. The fed could target the TED or corporate spreads as ameasure of loose or tight policies now that the Fed funds rate is near zero.

Another alternative would be a direct measure of equity prices. Of course, this has inherent difficulties. A growing economy could see rising equity prices that are unrelated to inflation, yet it may be the time to have further discussion on how to measure financial tightness in a systematic fashion and use this for controlling policy. Most of the risks that have been faced in the last two years have been associated with dislocations in the asset or credit markets and not with direct goods inflation so a measure that look at these risks may better serve the Fed.