Why Do Monetary Policymakers Lean with the Wind During Asset Price Booms?

In this paper we explore the optimal policy reaction to an asset price boom. Empirical evidence shows that the monetary policy stance is typically loose during asset price booms. Employing a modified New Keynesian sticky price model we show that this policy of leaning with the wind can be attributed to the forward-looking nature of the private sector's expectations. Agents incorporate the macroeconomic consequences of a looming asset price bust in their expectations. The expectation-induced deviations of output and inflation from their targets enforce a monetary loosening before the bust occurs. Furthermore, we argue that a policy of benign neglect towards asset price movements, as often advanced by monetary practitioners, is (generally) not optimal in welfare terms