Central banks must care about asset prices

By: Wolfgang Münchau

The International Monetary Fund last week gave central banks some wicked advice*. They should no longer ignore residential property prices when setting interest rates. At the same time, the IMF recommends central banks should retain their inflation-targeting frameworks. It all sounds very plausible. Unfortunately the two goals are inconsistent.

The reason why central bankers in the past refused to take explicit account of property and other asset prices is not accidental. The New Keynesian forecasting models, with which central banks predict future output and inflation, have no explicit role for money, financial markets and asset prices. The way modern central banks deal with asset price bubbles is to do nothing until they burst and then clean up the mess. For the New Keynesian framework to work well, a narrow inflation measure is not a design error. It is essential.

The problem is that you cannot just shove an asset price formula into the model. Of course, central banks can always try “interpreting existing mandates more flexibly”, as the IMF put it – or lie about your policy. The IMF approvingly cites the case of the Swedish Riksbank, which had persistently undershot its inflation target from 2004 until 2006, yet refused to cut interest rates. The Riksbank was concerned about the country’s property bubble at the time. I think the Riksbank had a point. But it was dishonest to pretend that it was an inflation targeter at a time when it clearly was not. It was happy to let inflation fall outside the target rate for a prolonged period. The whole point about direct inflation targeting is to stick to your target in adverse circumstances so you can stabilise inflationary expectations. When you worry about inflation this year and the Stockholm property market the next, people become confused. Worse, the two targets often require opposite action. For example, during the credit and housing bubble, asset prices were rising but inflation was low. Now inflation is rising and asset prices are falling. So what do you do?

But the IMF’s fundamental analysis is correct. The residential property market drives the business cycle. The more liberal a country’s mortgage market, the greater the influence of housing on the economic cycle and the greater the influence of monetary policy on house prices.

The IMF ranks various countries according to a metric of mortgage market liberalism, with the US on top and Germany, France and Italy near the bottom, as one would expect. The metric is made up of several factors, including typical loan-to-value ratios. The UK and especially Spain are ranked surprisingly low, which I find implausible. I would rate the UK property market as among the most susceptible to a downturn in the credit cycle. For example, last week UK mortgage lenders caused near-panic by withdrawing popular 100 per cent mortgages for first-time buyers. At a time of vastly inflated property prices, first-time buyers will now have to save money up front. Maximum 90 per cent mortgages in a stagnating or falling market could easily lead to falling demand.

So what should a central bank do? It should seek to stabilise a broad price index, which should include not only oil and food but also a realistic measure of property prices. By this I do not mean a rental component but some element of the residential property market itself. In the UK, the all-items retail price index is one such measure (since it includes mortgages). I know that broad inflation indices are annoying from a central bank’s perspective. Those indices do not react well to policy action. But the goal of monetary policy surely cannot be to make life easy for central bankers.

I suspect the New Keynesian policy framework will go down in the history of rules-based monetary policy frameworks as a fair-weather construction that worked as long as global inflation was low. Now that inflationary pressures are rising and asset prices are falling, the only way central banks can avoid a calamity is either by abandoning single-minded core inflation targeting – or by deceit.

*The Changing Housing Cycle and the Implications for Monetary Policy, chapter 3, IMF World Economic Outlook, April 2008; www.imf.org

© The Financial Times Limited 2008

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