##gnment 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

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 nontradables inflation of around 4½ per cent. graph 2 the link between house price inflation and the cpi ( annual percentage change ) central banks also pay attention to asset prices because they contain information that ’ s very useful when setting monetary policy