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Falling Natural Rates, Rising Housing Volatility and the Optimal Inflation Target

Klaus Adam (), Oliver Pfäuti () and Timo Reinelt ()

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: The decline in natural interest rates in advanced economies over the past decades has been accompanied by a signi cant increase in the volatility of housing prices. We show that the monetary policy implications of these macroeconomic trends depend|in the presence of a lower-bound constraint on nominal rates|on the source of increased housing price volatility. If housing price expectations are rational, increased housing price volatility re ects more volatile housing demand shocks. Under optimal monetary policy, average in ation then increases only minimally, as average natural rates fall and housing shocks become more volatile. Instead, if housing price volatility is partly due to speculative housing price beliefs, as suggested by survey data, then lower natural rates endogenously trigger larger uctuations in subjective housing price beliefs and housing prices. A belief-driven increase in housing price volatility causes also the natural rate of interest to become more volatile. This exacerbates the lower-bound problem, especially when average natural rates are low. Under optimal monetary policy, average in ation then rises much more strongly following a fall in natural rates, rationalizing larger increases in the in ation target.

Keywords: inflation target; real estate booms; natural rate (search for similar items in EconPapers)
JEL-codes: E31 E44 (search for similar items in EconPapers)
Pages: 62
Date: 2020-11
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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