Stefan Ingves: Housing and monetary policy - a view from an inflation
targeting central bank
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Federal Reserve
Bank of Kansas City's Economic Symposium, Jackson Hole, Wyoming, 1 September 2007.
* * *
I am honoured to have been asked to participate in this final panel debate in such
distinguished company. What I intend to bring to this panel is an account of how Sveriges
Riksbank, an inflation targeting central bank, takes into consideration developments in asset
prices, house prices in particular, and our experience thus far of doing so. Hopefully this
account will be of interest, since it illustrates some of the challenges - analytical and
pedagogical - that policy makers face when deciding on the appropriate way of bringing
asset price developments into monetary policy decisions making.
In going through events in the past few years I will also touch on the criticism that the
Riksbank has received from various directions - members of the public in Sweden, financial
market participants, and from some members of academia. As a matter of fact, some of the
criticism levelled at the Executive Board has come from within the Bank, i.e. from members
of the staff. As I will elaborate below, this reflects that there are no simple answers to the
question of what the proper role is for house prices in an inflation targeting framework.
Let me say at the outset what I and other members of the Executive Board have said on
many occasions - Sveriges Riksbank does not have a target either for the level of house
prices or for house price inflation, or for any other asset price for that matter. However, when
we observe long periods of high growth rates in asset prices and debt, growth rates that
appear to be unsustainable in the long run, our view is that it is not reasonable to completely
ignore that there may be risks associated with this, even though it is difficult to give
consideration to these risks in any simple manner in our regular forecasting process. What
this view has meant in practice is fairly marginal changes in the timing of our interest rate
changes and substantial public oral and written focus on the issue. Having said that, and for
the benefit of those not familiar with the monetary policy framework in Sweden, let me
provide a short background.
Sveriges Riksbank is an inflation targeting central bank, having adopted an explicit target for
inflation in 1993, effective from 1995. Our goal is to keep inflation at 2 per cent in terms of
changes in the CPI. The regime has now been in place for well over ten years, and there is
broad agreement that the regime has been a successful one; CPI-inflation has been low and
stable over the period, averaging around 1.3 per cent, while the real economy has
experienced annual growth of around 3 percent. Measures of underlying inflation that
exclude the effects on CPI of our own interest-rate changes have been closer to the target of
2 per cent, as have inflation expectations (see Figure 1).
Figure 1: Inflation Expectations in Sweden
Money market agent expectations, annual
percentage change
5 5
Inflation expectations
CPI
4 4
3 3
2 2
1 1
0 0
-1 -1
-2 -2
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Sources: Prospera Research AB and Statistics Sweden
Figure 2: Real estate prices
Index 1996 4th quarter = 100
350 350
Australia
UK
300 United States 300
Sweden
250 250
200 200
150 150
100 100
50 50
0 0
97 98 99 00 01 02 03 04 05 06 07
Sources: Australian Bureau of Statistics, Nationwide, OFHEO and Statistics
S eden
Since my remarks are to be on the role that house prices have played in Swedish monetary
policy in recent years the following should be noted too. Since 1996 nominal house prices in
Sweden have more than doubled (the increase is around 140 per cent, see Figure 2) and the
average price for a coop condominium has risen even more. The corresponding figures
concerning the increase in housing prices are for the UK +220%, the US + 110 %, Australia +
140 %. In recent years, household borrowing has also increased, both in absolute terms and
relative to household income.
Rapidly growing house prices and household indebtedness were increasingly highlighted by
members of the Executive Board from around 2004 and onwards. From 2006 statements
regarding the development of house prices and household indebtedness have often been
included in press releases following monetary policy decisions, and discussions in the
minutes from the Executive Board meetings.
The role of house prices in an inflation targeting regime
With these institutional and other details in place, let me turn to a more general discussion of
the role of house prices in an inflation targeting regime.
As we are all well aware, the debate regarding the role of house prices in the formulation of
monetary policy has yet to settle in a working consensus. There are many ways in which the
different views in this ongoing debate can be summarized. Without claiming to have captured
all views, and perhaps exaggerating a bit, let me mention three: "textbook flexible inflation
targeting", "leaning against the wind", and "extending the forecast horizon". Let me elaborate
on each category in turn and then return to our view.
Textbook flexible inflation targeting
The textbook account of a flexible inflation targeting regime explains that when interest rates
are set to bringing inflation back to the target, consideration is also given to the effects on the
real economy; an appropriate balance between inflation and real variability is sought, which
implies that an immediate reversal to the target is not an end in itself. Textbook accounts of
flexible inflation targeting typically give the following answer to the question of how asset
prices should be factored into the monetary policy decision: monetary policy should respond
to changes in asset prices to the extent that they affect the inflation and growth forecasts.
Thus, there is no independent role for e.g. rapidly rising house prices. Their effect on the
monetary policy decision should come only through their effect on the inflation and growth
forecasts. This recommendation, and the assumptions on which it is based, is something I
will comment more on, below.
Leaning against the wind
Another view often put forward is that a central bank can bring about better outcomes for
inflation and output by reacting to rapidly rising asset prices, over and above their
implications for inflation and growth. In short, there are two arguments for this: (i) engaging in
such behaviour - let's call it "leaning against the wind" - in situations when an asset price is
changing due to non-fundamentals can dampen the effects of the unmotivated price change
on the real economy and thereby prevent an inefficient allocation of resources; (ii) if the
market knows that the central bank engages in "leaning against the wind" activities the
probability will fall of non-fundamental price changes arising in the first place.
The key issue here is, of course, identifying price changes that are driven by
nonfundamentals. This problem cannot be overly emphasized. But difficult or not, it is an issue
that central banks cannot ignore. If prices of houses or other assets are partly driven by
factors that are hard to explain and that are believed to give rise to inefficient allocations and
risks of large fluctuations in real economic activity and inflation, such events will, in one way
or another, find their way into our thinking about monetary policy.
Extending the forecasting horizon
In practice, most inflation targeting central banks have chosen to adopt forecast horizons of
two to three years, at least in external communication and official documents. In this
environment, the idea that a central bank can need to extend the horizon over which it
constructs inflation and output forecasts is one that has been heard from many central
banks. Doing so may enable the central bank to take into consideration the longer-run
consequences on inflation and production of potentially large movements in asset prices and
levels of indebtedness that have been built up over long periods of time.
From a theoretical perspective, central banks should always look at inflation and growth over
the indefinite future, and thus this seems a reasonable proposal. At the same time one must
remember that in practice it is difficult to construct forecasts for longer horizons that actually
contain more information than that which is contained in the forecast for the coming two to
three years. Also, the horizon may in fact have to be very long to illustrate the issues at hand.
The Riksbank view
The monetary policy strategy followed by the Riksbank is that of flexible inflation targeting.
When setting interest rates we consider not only the outlook for inflation but also the
development of the real economy. In most situations, monetary policy is focused on bringing
inflation back to target within a two-year horizon, which is deemed as providing enough time
to allow consideration to be given to developments in the real economy. In certain
circumstances, if inflation has deviated substantially from the target, it is reasonable to let
inflation return to target at a slower pace, provided this does not undermine the credibility of
the inflation target. Doing so will dampen the effects on the real economy of the policy
measures that are adopted in order to return inflation to the stipulated target.
Described in this way, the Riksbank's strategy is close to the textbook treatment of flexible
inflation targeting. However - and here I come to an area where the Riksbank has recently
been criticized - we do also allow for taking into consideration developments in asset prices,
including house prices. As explained in the policy document "Monetary Policy in Sweden"
"the paths of asset prices and indebtedness can at times be either difficult
to rationalize or unsustainable in the long term. This means that there are
risks of sharp corrections in the future which in turn affect the real economy
and inflation. ...In practice, taking risks of this kind into consideration can
mean that interest rate changes are made somewhat earlier or later, in
relation to what would have been the most suitable according to the
forecasts for inflation and the real economy." (p. 15-16)
Why is such a statement included in the Riksbank's monetary policy strategy? Why is it for
instance not sufficient to simply follow the prescriptions of the textbook account of flexible
inflation targeting? This type of criticism was raised in a recent external evaluation authored
by Francesco Giavazzi and Frederic Mishkin.
A close adherence to the textbook account of flexible inflation targeting requires a belief that
the analytical tools and models currently available have accurately captured the important
linkages in the economy. It requires a belief that we as central bank economists have a solid
understanding of all important aspects of the monetary transmission mechanism. In my
opinion - which is neither very original nor controversial - we are not quite there yet.
One such area in which our understanding can be improved concerns the credit markets. A
fundamental problem is that we presently lack the analytical tools that accurately capture the
role played by credit and house prices in the economy. The research of Chairman Bernanke
and others regarding the importance of collateral constraints and the financial accelerator
effects on firms' investment have paved the way for an increased understanding of these
complex issues. Their research has been extended by others to the household sector - the
idea being that as house prices increase, credit-constrained households are able to engage
in so-called mortgage equity withdrawals and raise their consumption. In time, insights from
these models will help us to better analyze house prices and household debt in integrated,
general equilibrium setups. In fact, this is an area into which the Riksbank is putting some
modelling efforts, trying to understand how credit markets can be integrated with our general
equilibrium approach to fluctuations in growth and inflation.
In the future we will hopefully be better able to analyze how developments in asset prices
influence the future course of inflation and output, and how the monetary transmission
mechanism is affected by changing asset prices. Until we are confident that our various
formal models adequately capture the risks that we in the Executive Board are concerned
about, we will have to continue relying heavily on judgement when taking such effects into
account in the conduct of monetary policy.
Let me reflect a bit on what in my mind has brought about this stance. On the one hand we
normally talk about inflation targeting in a two year time perspective, on the other hand there
are risks associated with credit and asset prices that may lead to substantial deviations from
the forecasted inflation and output paths. The judgement issue then becomes one of meeting
or not meeting the target at the two-year horizon versus the risk of costly deviations both
within and beyond the normal forecast horizon. Such deviations are likely to be low
probability events but with high costs in inflation and real terms should they occur. We know
that these developments are very hard to predict using the standard models we normally rely
on but I do believe it is our responsibility ex ante to reflect on how to avoid future negative
outcomes. The nature of such outcomes will vary depending on what part of the asset market
that generates the risks, the market microstructure available for sorting out a problem in an
efficient manner and the extent to which monetary policy is able to counteract the risks. Here
we certainly can deepen our understanding of how different imbalances unwind and what the
costs are. We often talk about asset markets in very general terms without going into any
great detail.
In this context one can argue that monetary policy is a blunt instrument and considerations of
risks associated with credit and asset markets should be left to the supervisory structures in
place. In principle, supervisory rules can be fine tuned towards different asset markets in a
more precise way than monetary policy. If prudential rules are or become binding we are also
likely to see some macroeconomic consequences of these policies. In my view it is far from
obvious how much weight is to be put on monetary policy and how much on supervision.
Monetary policy can play a role, albeit perhaps a limited one, not the least because this will
help to manage inflation expectations over the long term. Furthermore, when imbalances
build up monetary policy and supervision can support one another.
Criticism from different sides...
I mentioned in the beginning that we have been criticized from many angles. Thus, in the
very same year that an outside review came to the conclusion that the Riksbank had given
too much independent weight to house price developments, other Riksbank-watchers
criticized us for neglecting the ongoing build-up in house prices and debt levels. Some
market commentators in Sweden have in the past year referred to the rapidly rising house
prices as a reason for increasing the repo rate at a substantially faster rate than our
published interest rate forecasts. House prices have, as I mentioned in the introduction,
increased by 140 per cent since 1996; annual changes are now in the vicinity of 8 per cent,
down from around 13 per cent a year ago. As in many other countries, these developments
have been the subject of much attention in the media, and calls have been made for the
Riksbank "to do something about it".
Here some pedagogical challenges arise. We must explain that we do not target house
prices but that we do not ignore risks associated with them. This is far from having a target
for house prices. House prices vary in response to changing economic conditions, one of
them being the stance of monetary policy. In Sweden, as in many other countries, house
prices have increased in an environment characterized by strong macroeconomic conditions,
rising disposable incomes and increasingly sophisticated financial markets. In this
environment it is impossible to pin-point an appropriate rate of change in house prices. But
policy makers always have to take decisions under a high degree of uncertainty.
Concluding remarks
In conclusion, let me say that we have tried to be open and honest about the uncertainties
surrounding the effects of house price developments on the rest of the economy and the
appropriate monetary policy response. We have, in fact, been open about our own
uncertainties and the differences in opinion, albeit small, that have arisen at times. This may
have given rise to "confusion about the confusion". But one could also say this comes with
transparency - outside observers were very aware of the discussions that were being held
and the uncertainties involved.
Inflation targeting so far has proved to be a successful way of conducting monetary policy,
but there are unresolved issues and one concerns the treatment of house and other asset
prices; it has been hard to formally fit asset price developments into the frameworks
researchers and central banks use when they study inflation targeting.
The models currently available to us and other policy makers, while indispensable as tools
for organizing our thoughts concerning difficult matters, are incomplete representations of
complex economies and cannot be the sole input into our analysis. Thus, while the academic
community and researchers at central banks - including Sveriges Riksbank - continue their
efforts to formulate models that combine firm founding in economic theory with good
empirical properties, policy makers have to use judgement and take into account those
relationships that history and experience suggest are of importance.
In my view it is well worth keeping an eye on house prices and other asset prices and
passing judgement on the risks that their developments may give rise to. If the probability of
very negative outcomes can be reduced ex ante I believe this to be a good thing and a better
solution compared to picking up the pieces ex post.