Monetary Policy and Asset Price Interactions in India: Should Financial Stability Concerns from Asset Prices be Addressed Through Monetary Policy?

The dynamic interactions between monetary policy and asset prices have conventionally been examined in terms of the asset price channel of transmission of monetary policy, given the pre-crisis analytical consensus against the use of monetary policy to respond directly to asset price inflation.In the post sub-prime crisis period, however, there has been an overwhelming intellectual support for revisiting the issue of whether monetary policy should become more sensitive to asset price trends and respond proactively to prevent any build up of bubbles.In the Indian context, this paper provides empirical evidence to explain the relevance of a policy of no direct use of the interest rate instrument for stabilising asset price cycles.While the asset price channel of monetary policy is clearly visible in empirical estimates, there is no evidence of monetary policy responding to asset price developments directly.Asset price changes also do not seem to influence the inflation path, as per the impulse response analysis in a structural VAR model.This suggests why monetary policy may continue to refrain from responding directly to asset price cycles.Credit market shocks, however, explain significant