eva srejber : should monetary policy subdue inflated high debts and asset prices in an inflation - targeting regime? speech by ms eva srejber, first deputy governor of the sveriges riksbank, at the adam smith seminar, thun, switzerland, 28 june 2006. references for the speech can be found on the sveriges riksbank ’ s website. * * * introduction today i intend to discuss how central banks should react to debts and asset prices that increase at a rate which is not sustainable in the long term. when the riksbank decided at the beginning of the year to raise its policy rate, saying that one of the reasons was the rapid rate of increase in household borrowing and house prices, this was perceived by some people as meaning that we had introduced a new objective for monetary policy. however, this is not the case. our focus then – as on other occasions – was on inflation developments. another factor was that we also wanted to avoid further pressure on the rate of increase in house prices and debts and thereby reduce the risk of a large fall in demand and a low inflation rate in the future. how should central banks behave in a situation like this, when models and forecasts indicate an inflation rate that is on target, while there is some risk that sharply rising house prices and debts will jeopardise the target later on? there is no common view on this issue among either central banks or academics. today i intend to give my views on these issues. i shall concentrate on the role played by elevated asset prices and indebtedness with regard to developments in demand and thereby price stability. let me begin with a brief summary of my speech : • many central banks are worried by rapidly growing house prices and lending over long periods of time. the historically very low interest rate levels could create unrealistically low expectations of interest rates in the future. however, it is difficult to determine whether this development actually increases the risks to demand and inflation and whether – and how – monetary policy can in this case take these factors into account. • these risks cannot be captured by the traditional models and forecasting methods normally used by central banks, which means that opinions differ as to how the central banks should act. should we react in advance to subdue possible negative effects, or should we wait until a possible correction takes place? • my opinion is that we must make the best possible assessments and act in advance to try to prevent the risk of large corrections leading

decisions and in some way take into account the risks it envisages. in the description of the framework for the riksbank ’ s monetary policy, which we published recently it says : “ the riksbank routinely takes into consideration changes in asset prices and other financial variables ( exchange rates, house prices, share prices, household and corporate indebtedness, etc. ) in monetary policy decisions. this should not be interpreted as introducing targets for different asset prices or other financial quantities. however, situations may arise where the consequences for the real economy and inflation of the development of different financial variables threaten to become very unfavourable and serious without it being possible for that reason to quantify or capture this type of risk in the normal analytical and forecasting work. this means that there are risks of sharp corrections in the future which in turn affect the real economy and inflation. it may be necessary to take these risks into account in monetary policy decisions in a different way than in the normal approach, where the forecasts for inflation and the real economy for the next two years serve as the foundation. ” although it is difficult to quantify the risks related to strong and long - term growth in asset prices and debts using normal methods, there is a fairly large flora of research into how different types of imperfections can cause and reinforce the types of imbalances i have discussed. one research area, for instance, is based on psychological factors being able to lead to expectations becoming an independent driving force behind fluctuations in the real economy. if, for instance, the real return on a financial asset has been high over a long period of time, this may, according to some research results, affect expectations so that many believe that the return will be as high in the future, despite fundamental factors indicating a lower return. in efficient financial markets, the agents with forwardlooking rational expectations should be able to earn money by taking offsetting positions, but an unwillingness to take risks, difficulties in finding financing or regulations can mean that this is not possible to a sufficient extent. there are for example empirical studies indicating that investors appear to disregard the fact that an economic upswing is usually followed by a downswing and vice versa, which leads to them tending to take greater risks than they should in an upswing and vice versa in a downswing. another research area concerns imperfections in the credit markets, which lead to the current income and balance sheet having significance for consumption and investment, as lenders and borrow