Frederic S Mishkin: The role of house prices in formulating monetary policy
Remarks by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal Reserve
System, at the Forecasters Club of New York, New York, 17 January 2007.
* * *
Over the past ten years, we have seen extraordinary run-ups in house prices. From 1996 to the
present, nominal house prices in the United States have doubled, rising at a 7-1/4 percent annual
rate.1 Over the past five years, the rise even accelerated to an annual average increase of 8-3/4
percent. This phenomenon has not been restricted to the United States but has occurred around the
world. For example, Australia, Denmark, France, Ireland, New Zealand, Spain, Sweden, and the
United Kingdom have had even higher rates of house price appreciation in recent years.
Although increases in house price have recently moderated in some countries, they still are very high
relative to rents. Furthermore, with the exception of Germany and Japan, the ratios of house prices to
disposable income in many countries are greater than what would have been predicted on the basis of
their trends. Because prices of homes, like other asset prices, are inherently forward looking, it is
extremely hard to say whether they are above their fundamental value. Nevertheless, when asset
prices increase explosively, concern always arises that a bubble may be developing and that its
bursting might lead to a sharp fall in prices that could severely damage the economy.
This concern has led to an active debate among monetary policy makers around the world on the
appropriate reaction to the run-ups in house prices that we have recently seen in many markets:
Should central banks raise interest rates? And how should they prepare themselves to react if housing
prices decline? These are the issues that I will address today. The views I will express are my own
and not necessarily those of my colleagues on the Federal Open Market Committee.
Home prices, like other asset prices, have important effects on output and inflation. Home prices affect
the economy in two primary ways. First, when they begin rising, the expectation of further appreciation
tends to become built into the market. That expectation boosts demand for homes, which stimulates
new construction and aggregate demand. Of course, the sustained rise in prices can simultaneously
sow the seeds of a market correction by making houses progressively less affordable relative to
income, thereby limiting the demand for them and restraining additional construction. Second, higher
home prices increase household wealth, thus stimulating consumer spending, another component of
aggregate demand.
Because central banks are in the business of managing total demand in the economy so as to
produce desirable outcomes on inflation and employment, monetary policy should accordingly respond
to home prices to the extent that these prices are influencing aggregate demand and resource
utilization. The issue of how central banks should respond to house price movements is therefore not
whether they should respond at all. Rather, the issue is whether they should respond over and above
the response called for in terms of objectives to stabilize inflation and employment over the usual
policy time horizon. The issue here is the same one that applies to how central banks should respond
to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices
might be highly damaging to the economy, as they were in Japan in the 1990s, should the monetary
authority try to prick, or at least slow the growth of, developing bubbles?
I view the answer as no.
I will outline some conventional arguments for and against reacting to asset prices over and above
their direct and foreseeable effects on inflation and employment. I will also discuss some additional
reasons why central banks should not overly emphasize house prices in particular. Although I come
down squarely on the side of those who oppose giving a special role to house prices in the conduct of
monetary policy, I do think that central banks can take steps to ensure that sharp movements in the
prices of homes or other assets do not have serious negative consequences for the economy.
There is no question that asset price bubbles have potential negative effects on the economy. The
departure of asset prices from fundamentals can lead to inappropriate investments that decrease the
efficiency of the economy. For example, if home prices rise above what the fundamentals would
justify, too many houses will be built. Moreover, at some point, bubbles burst and asset prices then
return to their fundamental values. When this happens, the sharp downward correction of asset prices
can lead to a sharp contraction in the economy, both directly, through effects on investment, and
indirectly, through the effects of reduced household wealth on consumer spending.
Despite the clear dangers from asset price bubbles, the question remains as to whether central banks
should do anything about them. Some economists have argued that central banks should at times
"lean against the wind" by raising interest rates to stop bubbles from getting out of hand. They argue
that if a bubble has been identified, then raising interest rates will produce better outcomes. For
instance, William White, of the Bank for International Settlements, has said that "monetary policy might
rather be used in a highly discretionary way to respond to growing imbalances that were judged by
policymakers to threaten financial instability."2 Although central banks have generally not argued that
interest rates should be raised aggressively to burst asset price bubbles, statements suggest some
central bankers believe some leaning against the wind might be warranted. For example, in the
second half of 2003 and the first half of 2004, a minority of members of the Monetary Policy
Committee of the Bank of England argued for raising interest rates more than could be justified in
terms of the Bank of England's objectives for inflation over its normal policy horizon. They said that
such a move would help lower the probability of house prices rising further and make it less likely that
a house price collapse would occur later. Mervyn King, the Governor of the Bank of England, did not
advocate leaning against the wind but did suggest that, to prevent a buildup of financial imbalances, a
central bank might extend the horizon over which inflation is brought back to target. Statements from
officials at the European Central Bank also have suggested that the possibility of an asset boom or
bust might require longer than the usual one to two years in assessing whether the price stability goal
was being met.
The recent case of the Sveriges Riksbank, the Swedish central bank, is particularly interesting. I
studied the Riksbank in a report on monetary policy written with Francesco Giavazzi for the Swedish
parliament before I came to the Federal Reserve Board.3 We found that communications by the
Riksbank suggested to market participants that it was actually adjusting monetary policy to lean
against the wind of rapid increases in home prices. On February 23, 2006, the Executive Board of the
Riksbank voted to raise the repo rate 25 basis points (0.25 percentage points). This monetary policy
action was accompanied by a statement acknowledging that the inflation forecast was revised
Inflation Report
downward. In fact the published on the same day also showed that inflation forecasts
had been revised downward and were below the 2 percent target at every horizon. The Executive
Board's statement pointed out that "there is also reason to observe that household indebtedness and
house prices are continuing to rise rapidly."4 It then said: "Given this, the Executive Board decided to
raise the repo rate by 0.25 percentage points at yesterday's meeting." Not surprisingly, market
participants took this statement to mean that the Riksbank was setting the policy instrument not only to
control inflation but also to restrain house prices. A similar reference to house prices in explaining the
decision to raise rates was made in the press release of January 20, 2006.
The above statements suggest that some central bankers advocate that asset prices, and in particular,
house prices, should have a special role in the conduct of monetary policy over and above their
foreseeable effect on inflation and employment. There are several objections to this view.
A special role for asset prices in the conduct of monetary policy requires three key assumptions. First,
one must assume that a central bank can identify a bubble in progress. I find this assumption highly
dubious because it is hard to believe that the central bank has such an informational advantage over
private markets. Indeed, the view that government officials know better than the markets has been
proved wrong over and over again. If the central bank has no informational advantage, and if it knows
that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble
that could be identified with certainty by the central bank would be unlikely ever to develop much
further.
A second assumption needed to justify a special role for asset prices is that monetary policy cannot
appropriately deal with the consequences of a burst bubble, and so preemptive actions against a
bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability,
with the most recent notable example among industrial countries being that of Japan. In principal, in
the event of such a crash, monetary policy might become less effective in restoring the economy's
health. Yet there are several reasons to believe that this concern about burst bubbles may be
overstated.
To begin with, the bursting of asset price bubbles often does not lead to financial instability. In
research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century,
we found that most of the crashes were not associated with any evidence of distress in financial
institutions or the widening of credit spreads that would indicate heightened concerns about default.5
The bursting of the recent stock market bubble in the United States provides one example. The stock
market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which
were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result,
the recession that followed the stock market drop was very mild despite some severely negative
shocks to the U.S. economy, including the September 11, 2001, terrorist attacks and the corporate
accounting scandals in Enron and other U.S. companies; the scandals raised doubts about the quality
of information in financial markets and ultimately did indeed widen credit spreads.
There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to
produce financial instability. House prices are far less volatile than stock prices, outright declines after
a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value
ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than
the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the
life of the loan. Hence, declines in home prices are far less likely to cause losses to financial
institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures
are high. Not surprisingly, declines in home prices generally have not led to financial instability. The
financial instability that many countries experienced in the 1990s, including Japan, was caused by bad
loans that resulted from declines in commercial property prices and not declines in home prices. In the
absence of financial instability, monetary policy should be effective in countering the effects of a burst
bubble.
Many have learned the wrong lesson from the Japanese experience. The problem in Japan was not so
much the bursting of the bubble but rather the policies that followed. The problems in Japan's banking
sector were not resolved, so they continued to get worse well after the bubble had burst. In addition,
with the benefit of hindsight, it seems clear that the Bank of Japan did not ease monetary policy
sufficiently or rapidly enough in the aftermath of the crisis.
A lesson that I draw from Japan's experience is that the serious mistake for a central bank that is
confronting a bubble is not failing to stop it but rather failing to respond fast enough after it has burst.
Deflation in Japan might never have set in had the Bank of Japan responded more rapidly after the
asset price crash, which was substantially weakening demand in the economy. If deflation had not
gotten started, Japan would not have experienced what has been referred to by economist Irving
Fisher as debt deflation, in which the deflation increased the real indebtedness of business firms,
which in turn further weakened the balance sheets of the financial sector.
Another lesson from Japan is that if a burst bubble harms the balance sheets of the financial sector,
the government needs to take immediate steps to restore the health of the financial system. This
should involve structural improvements in the way banks operate, not bailing out insolvent institutions.
The prolonged problems in the banking sector are a key reason that the Japanese economy did so
poorly after the bubble burst.
A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy
is that a central bank actually knows the appropriate monetary policy to deflate a bubble. The effect of
interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest
that raising interest rates can diminish the acceleration of asset prices, others suggest that raising
interest rates may cause a bubble to burst more severely, thus doing even more damage to the
economy. An illustration of the difficulty of knowing the appropriate response to a possible bubble was
provided when the Federal Reserve tightened monetary policy before the October 1929 stock market
crash because of its concerns about a possible stock market bubble. With hindsight, economists have
viewed this monetary policy tightening as a mistake.
Given the uncertainty about the effect of interest rates on bubbles, raising rates to deflate a bubble
may do more harm than good. Furthermore, altering the trajectory of interest rates from the path
predicted to have the most desirable outcomes for inflation and employment over the foreseeable
horizon has the obvious cost of producing deviations from these desirable outcomes.
Because I doubt that any of the three assumptions needed to justify a special monetary policy focus
on asset prices holds up, I am in the camp of those who argue that monetary policy makers should
restrict their efforts to achieving their dual mandate of stabilizing inflation and employment and should
not alter policy to have preemptive effects on asset prices.
However, there is a further reason why I believe that a central bank should not put too much focus on
asset prices. Such a focus can weaken its public support, making it harder for it to successfully
conduct monetary policy to stabilize inflation and employment.
A central bank that focuses intently on asset prices looks as if it is trying to control too many elements
of the economy. Part of the recent successes of central banks throughout the world has been that they
have narrowed their focus and have more actively communicated what they can and cannot do.
Specifically, central banks have argued that they are less capable of controlling real economic trends
in the long run and should therefore focus more on price stability and damping short-term economic
fluctuations. By narrowing their focus, central banks in recent years have been able to increase public
support for their independence. A central bank that expanded its focus to asset prices could potentially
weaken its public support and may even cause the public to worry that it is too powerful and has
undue influence over all aspects of the economy.
Too much focus on asset prices might also weaken support for a central bank by leading to public
confusion about its objectives. When my co-author and I conducted our evaluation of monetary policy
in Sweden, I directly observed this problem. I heard over and over again in interviews with participants
from different sectors of Swedish society that the statements about house prices by the Riksbank
confused the public about what it was trying to achieve.
My discussion so far indicates that central banks should not put a special emphasis on prices of
houses or other assets in the conduct of monetary policy. This does not mean that central banks
should stand by idly when such prices climb steeply. Rather my analysis suggests that central banks
can take steps to make it less likely that sharp movements in asset prices will have serious negative
consequences for the economy.
Instead of trying to preemptively deal with the bubble - which I have argued is almost impossible to do
- a central bank can minimize financial instability by being ready to react quickly to an asset price
collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different
scenarios to assess how it should respond to an asset price collapse. This is something that we do at
the Federal Reserve.
Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that
commercial financial institutions and banking supervisors conduct all the time. They see how financial
institutions will be affected by particular scenarios and then propose plans to ensure that the banks
can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a
central bank can minimize the damage from a collapse of an asset price bubble without having to
judge that a bubble is in progress or predict that it will burst in the near future.
Another way that a central bank with bank supervisory authority can respond to possible bubbles is
through prudential supervision of the financial system. If elevated asset prices might be leading to
excessive risk-taking on the part of financial institutions, the central bank, as in the case of the United
States, can ask financial institutions if they have the appropriate practices to ensure that they are not
taking on too much risk. Working through supervisory channels has the advantage not only of helping
make financial institutions better able to cope with possible asset price declines but possibly also of
indirectly restraining extreme asset prices if they have been stimulated by excessive bank financing.
Also, reminding institutions to maintain risk-management practices appropriate to the economic and
financial environment could potentially help lessen a buildup of excessive asset prices in the first
place.
Even if the central bank is not involved in the prudential supervision directly, it can still play a role
through public communication, particularly if it has a vehicle like the financial stability reports that
some central banks publish. In these reports, central banks can evaluate whether rises in asset prices
might be leading to excessive risk-taking on the part of financial institutions or whether distortions from
inappropriate tax or regulatory policy may be stimulating excessive valuations of assets. If this appears
to be happening, the central bank's discussion might encourage policy adjustment to remove the
distortions or encourage prudential regulators and supervisors to more closely monitor the financial
institutions they supervise.
Large run-ups in prices of assets such as houses present serious challenges to central bankers. I
have argued that central banks should not give a special role to house prices in the conduct of
monetary policy but should respond to them only to the extent that they have foreseeable effects on
inflation and employment. Nevertheless, central banks can take measures to prepare for possible
sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to
the economy.