Asset Prices and Monetary Policy: Booms and Fat Tails in East Asia

February 2008

Abstract

Do housing and equity booms significantly raise the probability at the margin of the realization of extremely bad outcomes? This study addresses this question for a group of 8 East Asian countries. The main findings are the following: (i) Asset price booms in housing and equity markets, whether separately or jointly but especially in housing, significantly raise the probability at the margin that (a) the real output gap will be in the left tail of its distribution in which output is significantly below trend, and (b) the price-level gap will be in the right tail of its distribution in which the price level is significantly above trend. At the margin, the risk of the occurrence of these particular tail events due to asset price booms is largely asymmetric and does not apply to the tails of good outcomes; and (ii) Expected real output and price level outcomes that are either obtained without conditioning on asset price booms or are obtained conditional on asset price booms using the normal approximation underestimate the risk of tail events and lead to less pessimistic but misleading inferences. One implication for monetary policy is that an approach that is ex-ante more compatible with risk management may be appropriate.