Stephen D. Smith
Economic Review, Vol. 84, No. 3, 1999
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It is fairly obvious that in market-based economies prices act as a constraint on individual behavior, providing a means by which goods and services flow to those most willing and able to pay for them. But prices play an additional role in the economy—that of signaling the present and expected future state of affairs. Having accurate forecast information is particularly important to policymakers, who are concerned with acting in advance to avoid bad economic outcomes rather than simply reacting to events.
This article reviews the theoretical literature regarding the extent to which asset prices aggregate information and examines evidence on the ability of financial asset prices to forecast inflation, real output or consumption, and recessions. Given the available evidence, the author finds it difficult to argue that monetary policymakers should give more weight to financial market variables. What can be argued is that, according to theory, financial asset prices should aggregate at least some information about future performance of economically important variables.
The author concludes that more work is needed along both theoretical and statistical lines for collectively figuring out what role, if any, financial asset prices or yields should play in forecasts used in conducting policy. Meanwhile, these variables will remain at most a source of information that policymakers can choose to use as a supplement to more traditional indicators.
September 1999