Asset prices and Monetary Policy
to
to the Canterbury
Employers’ Chamber of Commerce
Christchurch
30 January 2004
It has long been a tradition that Reserve Bank Governors begin their year with a speech to the Canterbury Employers’ Chamber of Commerce and because the economy of Christchurch is focussed on exporting the topics picked have often been of particular interest to the tradable sector. Given current concerns about the exchange rate, you may have expected a talk on that subject. However, I want to talk about something else – a topic which may seem more esoteric, but in particular circumstances can be very important. Indeed, it is a topic that has been of considerable relevance to New Zealand from time to time over the years.
Among central bankers right now one of the key topics of debate is
whether monetary policy should actively seek to encourage asset
price stability. The sharp end of this is whether monetary policy should seek
to prevent or at least reduce asset price bubbles? This is exemplified by
questions such as whether Japan’s long-running recession and the US
“tech wreck” could have been ameliorated by monetary policy
constraining the events that preceded them.
Before going further, I should define my terms a bit. By an asset price
I mean the price of something that one buys to generate income or to sell for a
profit later. Examples are physical assets - like housing, land, other
buildings and collectables like paintings or exotic cars - and financial assets
- like shares, bonds and other financial instruments. By consumer prices I
means things one buys to consume, like milk, petrol, a visit to the doctor and
ordinary cars. Remember also that asset prices often behave more erratically
than consumer prices, being slower to react to changes in supply and demand.
Prices of, for example, fruit and vegetables move constantly to match up buyers
and sellers. Asset prices are seldom that appealing in terms of classic
economics.
Under the Reserve Bank’s Policy
Targets Agreement (PTA) the Bank is required to ensure price stability, as
measured by the Consumers Price Index (CPI), and, subject to this goal, to avoid
unnecessary instability in output, interest rates and the exchange rate. Asset
prices are not included in the CPI. Thus the question is should monetary policy
sometimes look ahead of its normal time horizon and try to offset the potential
damage down the track to consumer prices and economic stability that can occur
when asset prices tumble?
Monetary policy automatically takes asset price developments into
account
The first point I need to make is that day-to-day central banks pay attention to asset prices when setting monetary policy, even when, as in New Zealand, their formal focus is exclusively on consumption prices.
This is primarily because asset price movements impact on CPI inflation
and large movements in asset prices can have significant implications for CPI
inflation. For starters, in the case of physical assets, if their prices are
rising faster than general inflation, people try to build or create more. For
example, if the price of paintings is going up artists get painting. To do that
they have to buy more paints, brushes and canvas, putting pressure on prices of
these materials.
In addition to that direct impact, asset price movements – physical
and financial - also feed into CPI inflation due to the so-called “wealth
effect”. As asset prices rise, people tend to feel wealthier. Some people
go shopping as a result, and in an economy already running at full steam this
gives inflation a push. This can apply with any kind of asset, but in New
Zealand we see this mostly through house prices, due to the high proportion of
home ownership here, as well as the large proportion of household wealth
associated with housing, as illustrated in graph 1.
Graph 1
Household wealth: housing and net financial assets
Asset prices also feed through into spending and hence inflation in other
ways. For example, asset price increases improve balance sheets, increasing the
borrowing power of firms and individuals. Increases in net worth tend to
increase the willingness of lenders to lend and borrowers to borrow,
facilitating a general expansion in spending as well as an expansion in spending
on the construction of appreciating assets.
In New Zealand, for example, house price inflation can lead to greater
demand for houses, and price increases in construction-related goods and
services. These goods and services are directly included in the CPI making up
about 8½ per cent. Lately, “purchase and construction of new
dwellings” has been notching up price increases approaching 7 per cent
year-on-year. This is much higher than the CPI average of around 1½ per
cent (see graph 2), and contributed materially to our recent non-tradables
inflation of around 4½ per cent.
Graph 2
The link between house price inflation and the CPI
Central banks also pay attention to asset prices because they contain
information that’s very useful when setting monetary policy. Normally
asset prices reflect perceptions of future income streams that the assets will
earn. Therefore, asset prices tell us something about how people think the
economy will perform in the months and years ahead.
Accordingly, in the ordinary day-to-day operation of monetary policy
asset prices matter. Also, day-to-day, when the Reserve Bank raises or lowers
interest rates to keep CPI inflation where it should be, this also tends to
partly constrain rising or falling asset prices in a desirable way. So most of
the time asset and consumer prices roughly track together and asset prices
present no particular problem for monetary policy or the economy. That’s
most of the time.
The building and bursting of big speculative bubbles
There are however times when things get more difficult and asset prices move well out of line with underlying economic fundamentals.
For example, in Japan real estate prices and the equity market shot up
through the 1980s, with the Nikkei getting to extraordinary levels before the
inevitable collapse which took 60 per cent off equities in 3 years and 70
percent off real estate prices over the following decade. Economic growth
struggled, averaging only 2 per cent in the 1990s compared to 4 per cent in the
1980s.
In Sweden real estate prices boomed in the second half of the 1980s,
nearly doubling over that time. The boom ran out of steam in 1991, and the
correction was severe enough to require the rescue of a good deal of the Swedish
banking system. Over the first 3 years of the 1990s, Sweden's economy shrank by
nearly 10 per cent.
And in the US the NASDAQ increased fivefold over 3 years in the late
1990s, before losing all of that ground by early last year. With the boom
having helped the US economy grow at an exceptional pace during the 1990s, the
collapse helped send that economy nearly into recession.
These examples hopefully make clear that this goes far beyond just
housing assets, and includes equities or shares, commercial property, rural
property and a wide range of financial assets.
In each of these cases, at least early on in the episode, asset prices
were behaving “normally” and asset prices reflected reasonable
expectations of the earnings prospects of those assets. A variety of things can
cause expectations of future earnings prospects to be revised either up or down,
and this will of course affect the prices of the assets. As farmers in the
audience know, rural land and stock prices swing readily with peoples’
confidence about the future. The sharp rise in dairy land prices in following
the GATT agreement in the early 1990s was an example of how expectations can
influence asset prices.
But expectations of the future can sometimes go beyond the well-founded
and can turn out to be horribly wrong. Sometimes, asset prices can become
disconnected from reasonable expectations of future earnings, resulting in
speculative bubbles that cannot be justified by economic fundamentals. These
are situations where markets fail in a big way to get prices even approximately
right. Such mis-pricing can be exaggerated by rule-of-thumb, momentum, or herd
behaviour, or irrational exuberance if you like. It happens sometimes that
speculators convince themselves that someone else will pay still higher prices
for an asset in the future, and in such a situation prices can start bearing
less and less relation to any reasonable expectation of future income streams.
Classic examples of speculative bubbles include the tulip mania that
swept Holland in the seventeenth century, and the South Seas bubble which caused
the first big stock market crash in England in 1720. The more recent three
examples I have cited were mild by comparison with these earlier ones!
Although bubbles may persist for quite some time, experience shows that
asset prices eventually return to a level that is more consistent with
“the fundamentals”. Bubbles do reveal themselves in the end –
people are not fooled forever. Eventually mistakes in pricing become widely
recognised, and markets correct. This makes bubbles inherently temporary,
involving first expansion and then contraction. It is often only once the
contraction has taken place that we see how big the bubble was, or just how much
prices were misrepresenting economic fundamentals. But by then a lot of damage
may have been done.
Failures to get asset prices “right” won’t always be
obvious until prices have corrected, but in principle if we can’t square
rapid price increases for assets with any apparent fundamentals then we are
probably looking at a bubble. In extreme cases, that inability to square
developments with fundamentals may become obvious before the correction happens.
Speculative bubbles can do damage in two ways. First, they distort
resource allocation in the wider economy as people get fooled into investing in
the wrong things. Resource misallocation can also be caused by the consumer
price inflation that sometimes accompanies asset price bubbles, since inflation
makes decision-making more difficult.
Second, when the bubble bursts there is damage to consumer and investor
confidence, economic activity and potentially the financial system. Several
recent international studies[1] of asset price
booms and busts have documented substantial costs from asset price cycles.
The role of the financial system can be crucial to the consequences of a
bubble building and bursting. The economic consequences when bubbles burst
depends on the extent to which individuals and companies have taken on debts
that they cannot comfortably meet. Asset price changes typically involve
borrowing and lending in financial markets, because it is future income that is
being used to “fund” current expenditure. Generally, at least some
of the income from an asset is used to repay financial obligations associated
with the asset’s purchase. With speculative bubbles, future capital gains
– rather than future income – are often the main source of expected
profit. If the bubble bursts, and such capital gains aren’t forthcoming,
people have to look elsewhere for the money to service and repay their
debts.
Debt financing is an extremely useful feature of the economy. It
facilitates the reallocation of resources in the economy towards the most
profitable activities. Nevertheless, heightened debt can seriously backfire
when bubbles burst. In particularly severe cases, borrowers’ troubles
carry over to lenders as well, so that in a bubble situation financing, credit
and leverage may create financial fragility. Since the financial system is at
the heart of all economic transactions, any disruption to it can have
significant implications for economic activity. This fragility is sorely
exposed when the bubble implodes. These issues are well-illustrated by the
Japanese and Swedish cases referred to earlier.
Prudent lending practices can help to insulate lenders from serious
fallout associated with declines in asset prices, but even then a bubble can
still result in serious macroeconomic fallout. The bursting of the US high-tech
stock bubble in 2000, and the subsequent weakening in equity prices more
generally, was not accompanied by major financial sector problems, but it has
been followed by a sustained period of very weak economic growth. Stretched
balanced sheets, characterised by excess leverage, damaged business confidence,
over-investment in high-technology enterprises, and sharply increased costs of
new equity raisings all combined to hold back new corporate investment to such
an extent that economic growth stalled.
This brings us to the crunch question of whether central banks should try
to constrain asset price bubbles to avoid or at least reduce the disruption to
the real economy that can come from a bubble bursting?
Firstly, we need to recognise that this is difficult as it is very hard
to tell in advance whether or not any particular market changes are justified.
Forecasting the future is never easy. At each point in time, there tend to be
many plausible explanations associated with any given price movement, and it is
hard to separate temporary factors from more permanent ones until some time has
passed.
Secondly, pursuing a separate asset price objective could mean having to
compromise on our normal inflation objective. Seeking to stabilise rising house
prices or an overheated stock market might mean having to force inflation lower
than otherwise would be required. It might also mean greater variability in the
real economy, interest rates and, potentially, the exchange rate. That could
raise questions about the PTA’s requirement to conduct monetary policy to
maintain CPI price stability and avoid unnecessary volatility in those other
variables.
A further difficulty is that interest rates have limited power to affect
the perceptions which move asset prices in the first place. To materially
affect some asset prices, such as housing, interest rates might need to move
quite a bit, and probably by much more than would be required just to keep CPI
inflation comfortably within the target range. Since interest rate changes
affect not just house prices, but also the prices of most other assets, goods
and services, there would be secondary, unintended consequences, with
potentially serious consequences for the economy as a whole.
Timing also makes this difficult. Given the lag of 1 to 2 years that we
think applies between an interest rate move and its effect on the real economy,
the risk is high that policy moves would be mistimed and only make matters
worse. If interest rates are high at the moment that a bubble bursts, those
high interest rates will still impact on the economy two years on. This would
make the landing harder.
So, given both uncertainty over whether asset price increases have
overshot, and doubts over whether monetary policy responses are helpful for
known bubbles, one has to be cautious in leaning aggressively against an
increase in asset prices.
What about using other instruments besides the interest rate? There are not many appealing options for this. Some less developed financial systems use mandatory credit rationing, but this instrument is also very blunt, harming newcomers to the market, distorting resource allocation and potentially depriving the private sector of sound investment opportunities.
Another possible option – at least in theory – is to make
more use of prudential regulation. For example, could the capital ratio applied
to banks be used counter-cyclically? Could the risk-weight on credit exposures
secured by residential property be applied in ways that reduce swings in house
prices? From time–to-time we consider these kinds of issues, but have so
far always reached the same three negative conclusions.
First, such tools are unlikely to be very effective in addressing asset
price cycles. The implementation of policy changes would take time, after which
there would be a potentially long and variable lag in the impact on asset
prices. Second, although such tools are less blunt than the OCR in targeting
particular asset categories, they are nonetheless still relatively blunt
instruments, and would have impacts that go beyond those intended. Third, the
use of such tools for macroeconomic purposes conflict with the objective for
which such tools were originally designed – i.e. financial stability.
Indeed, the use of prudential regulation to moderate asset price cycles might
backfire in some circumstances, creating perverse incentives for banks to bias
their lending into riskier ends of the lending spectrum, which in turn could
reduce the stability of the financial system. These factors have led us to
reject the use of prudential tools as instruments for responding to asset price
cycles.
So where does that leave us?
As I have already explained, in the course of doing what we normally do
we automatically lean against detrimental effects of asset price movements,
since there is often a correlation between asset price inflation and consumer
price inflation. The harder question is what to do when a speculative asset
price bubble is not accompanied by current or near-term inflation.
Responding to a bubble bursting is relatively obvious. The collapse of
big speculative bubbles is often accompanied by recession and disinflation or
even deflation. The Japanese case illustrates the point. A rapid monetary
response, aggressively if need be, to a sudden collapse in asset prices would be
consistent with the PTA, assuming there was also a substantial risk of consumer
price disinflation.
Responding to an emerging bubble is more challenging. I have presented
reasons why it is sensible to prevent the emergence of large speculative asset
price bubbles, if possible. And I have presented reasons why that would be
difficult to achieve, and why it would be risky to try. Nonetheless, it seems
to me that the scale of the fallout from the build-up and bursting of very large
asset price bubbles warrants taking some risks in an attempt to moderate –
and that’s all that one might hope for – the problem. And it seems
to me that there are cases when the asset price misalignment is sufficiently
obvious that one can be confident enough to take the risk.
But I need to be clear that such situations are likely to be rare indeed.
And the risks may be considerable. We are talking about circumstances where
monetary policy may well have to be quite tight – tighter than would be
the case if the sole objective was to keep consumer price inflation within the
target range. In such circumstances, I expect many audiences would say that the
Bank was unnecessarily squeezing growth from the economy. It would be a
foolhardy central banker who would take such risks lightly.
That said, as I interpret my mandate, it does permit me to take such
risks in rare circumstances. As I explained in an earlier speech, the PTA
clearly requires monetary policy to be forward-looking. Normally, we would
think in terms of the next three years. But, as I indicated then, there will be
exceptions. Given the potentially long-lived nature of asset price
misalignments, it may occasionally be helpful to take a longer view of when
risks might eventuate, how best to insure against them, and at what price. As a
recent IMF study[2] has pointed out, in effect
an asset price boom can change the trade-off between current and future
macroeconomic objectives. A new element enters the picture, which involves
trading off the risk of severe economic dislocation further down the track with
the near-term cost of reducing that risk.
Recent New Zealand house price developments in context
The next and obvious question is whether or not the recent run up in house prices in New Zealand constitutes a bubble so severe that it warrants a one-off additional monetary policy response, as described. Such a response would drive overall inflation to near the bottom or even below the 1 to 3 per cent target range in the PTA, thereby letting the air out of the bubble to avoid a collapse later. The immediate answer is no, though of course, in terms of the day-to-day controlling of consumer price inflation, housing is still the biggest thing being faced at the moment.
Over longer periods of time, real house prices are determined by the
balance between underlying demand and supply conditions. There are nevertheless
some important idiosyncrasies to housing markets that should be borne in mind.
On the demand side, such factors include demographics, migration, growth in
household disposable income, features of the tax system and the average level of
mortgage interest rates. On the supply side, factors include improvements in
the existing housing stock, the availability of suitable building sites, and
construction costs.
Although the demand for housing can shift quite dramatically in a short
space of time, the housing stock is relatively inelastic. It takes time to
build new houses and the capacity of the construction sector to provide them
also takes time to adjust to variations in demand.
Accordingly, housing prices are prone to quite significant short-term movements. Extra demand for housing due to migration, for example, can create supply constraints given the time taken to plan and construct new housing. In New Zealand, the correlation between net migration inflows and house price inflation is striking, as illustrated in graph 3.
Graph 3
Migration and house prices
The price signals given by the housing market thus have to be treated with caution. Compared to markets for financial assets, the housing market is relatively slow to adjust, with long and variable times to close sales, and with, beforehand, much uncertainty about final closing prices, if deals are even reached. Aggregated statistics on house price movements are “noisy” indicators of the future outlook for the housing sector. Past prices are not always a good indicator of future prices. Also, data on residential real estate prices are not always of a high quality.
This can mean that the housing sector is susceptible to over- and
under-shooting. Initial one-off increases in house prices may be misinterpreted
as increases in a trend, leading to further moves in the same direction, giving
an impression that a major trend shift is underway even if in fact it
isn’t. Because of the noisiness of the price signals, it can take a long
time for this sort of thing to correct. Eventually, as for other types of
assets, house prices do correct, either by falling outright, or by prices
treading water for years until fundamentals have caught up.
Do recent developments, in light of this susceptibility to over-shooting,
imply that the housing market is in such a speculative bubble that an unusual
monetary policy response is warranted? In some periods of our history, house
prices and rural land prices have both moved through large cycles, both up and
down – with the downs more noticeable in real terms (see graph 4). These
real declines were sometimes masked by high inflation, which may have fed the
false perception in some quarters that house prices never go anywhere but up.
In the current low inflation environment, real house price declines as in the
past would show up as outright declines in dollar prices.
Graph 4
Property prices
There is no doubt that we have seen quite strong increases in house prices in New Zealand in the last year or so. Some of that is justified by fundamentals, some simply reflects the fact that, in a small economy, with a small housing stock, it does not take much increase in demand to have a big effect on house prices. But some of the recent increases may also reflect excessive exuberance among some investors.
Thus some people today may be incorrectly convincing themselves that
level shifts associated with lower mortgage interest rates are in fact shifts in
the trend of prices, that house prices only rise, and that someone can always be
found who will pay more for a property. For a time, this behaviour can be price
reinforcing, but eventually some unhappy soul will be stuck holding the bag.
There are elements of speculative bubble behaviour present in recent
house price developments. While that bodes ill for some individuals, however,
it does not seem at this stage to be large enough, or of a character, to
generate significant fall-out for the overall economy when the correction
happens – as it will.
In terms of potential risks to the economy and to financial stability, a
bubble in residential housing is less of a concern than a bubble in commercial
property or in the stock market. On average, banks’ residential mortgage
portfolios are much more stable than other loan portfolios. The historical loan
loss on residential lending is very low indeed. Furthermore, recently the
Reserve Bank worked with the major retail banks in an exercise that involved
simulating a variety of shocks, including, amongst others, large falls in house
prices and incomes, a foot and mouth outbreak, large changes to interest rates,
the exchange rate and so on. The results of these tests suggest that the New
Zealand banking system is well placed to absorb some quite nasty shocks
including a large fall in nominal house prices. The current-day New Zealand
financial system has particularly prudent lending practices, strong
capitalisation, sound asset quality and strong parentage.
To be sure, there are legitimate reasons to be concerned that resources
are being misallocated as a consequence of incorrect perceptions about the
likely future course of house prices. But in terms of the ideas discussed
earlier, the economy-wide scale of resource misallocation and the fall-out from
a housing market correction do not appear sufficiently severe to warrant running
monetary policy unusually tight above and beyond the requirement to ensure
consumer price stability.
The scale of recent house price developments is by no means comparable to
the boom and bust in New Zealand equities in the 1980s. Graph 4, below, reminds
us of the dramatic bubble in equity prices that was experienced in the second
half of the 1980s, when equity prices doubled in one year and halved in the
next. This period is a reminder of how substantial shifts away from
fundamentals can be, especially with the benefit of hindsight! It defies belief
that equity prices at all times during this period were accurate reflections of
the true fundamentals-based value of traded New Zealand companies. The 1980s
experience was typical of the bubble phenomenon, as asset prices drifted to
levels where they didn’t appear to have much connection with the real
world, and then eventually they corrected back.
So should the Reserve Bank have tried to head off the share market boom
of the mid 80s, so as to avoid the 87 share market crash? That’s a really
hard call. Monetary policy was already very tight as the Reserve Bank valiantly
brought inflation down from very high levels, price stability not being achieved
until 1991. To have applied even more pressure probably would have been very
difficult. But now, with price stability in place, if our stock market was
starting to look like the left hand side of graph 5 then, yes, a Reserve Bank
Governor might well say extraordinary measures were required.
Graph 5
New Zealand equity prices
Conclusions
In this talk I have made the following points.
I’ve noted that, to some extent, monetary policy aimed at keeping
consumer price inflation under control automatically takes asset prices into
account in terms of their effect on general price inflation. However, even so,
sometimes asset price bubbles occur, causing economic damage. I’ve
suggested there are some very limited circumstances where monetary policy should
look beyond the immediate inflation outlook and respond more vigorously to asset
price developments. I have also noted that this carries risks and is difficult
to do. And I’ve recorded that the New Zealand housing market currently
does not warrant such a severe intervention, so that, for example,
yesterday’s interest rate increase was just part of the normal operation
of monetary policy to ensure continuing consumer price stability.
There’s an old adage that a popular central banker is seldom a good
central banker. Those in my trade have also been likened to dismal souls that
take away the punch bowl just when the party is getting boisterous. A central
banker trying to constrain an asset bubble would certainly not be flavour of the
month because everyone loves a bubble on the way up. Still, central bankers are
required to think-long term and sometimes that means taking decisions that
won’t be welcomed at the time but, in the longer-term, are in the public
interest.
(Assistance in the preparation of this text was provided by Nils Bjorksten, David Archer and other RBNZ staff.)
[1] Helbling and Terrones (2003), IMF; Bordo and Jeanne (2002), IMF; Detken and Smets (2003), ECB
[2] Bordo and Jeanne (2002)
