Asset Price Booms, “Fat Tails,” and Monetary Policy in East Asia

Abstract

This study provides empirical evidence for the proposition that asset price booms matter because they tend to bring about the worst output, price, and inflation outcomes in the case of eight East Asian countries, namely, Hong Kong SAR, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, and Thailand. The main findings are: (i) asset price booms in housing and equity markets, especially in housing, significantly lower the conditional mean of real output growth and raise those of the price-level gap and inflation, and also raise the conditional variance of all three variables; and (ii) expected real output and price-level outcomes that are obtained without conditioning on asset price booms, or are obtained conditionally on asset price booms using the normal distribution, both underestimate the risk of the worst outcomes occurring and lead to less pessimistic but misleading inferences. These findings are not premised on the ability of central bankers to be able to identify correctly asset bubbles ex ante. One possible implication for monetary policy is that central bankers ought to be wary about the occurrence of any large increase in asset prices and consider an approach that is ex ante more compatible with risk management.