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

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.