Why monetary policy to target asset prices wouldn’t work

Monetary policy is ultimately all about expectations. As Nick Rowe from Worthwhile Canadian Initiative points out, this feature of monetary policy makes the idea of “targeting asset prices” difficult – and ensures that any attempt to pop bubbles will be difficult, even if the bubbles are observable (which most of the time they are not):

Let’s imagine a conversation that might take place in the future, under a different monetary policy regime, where central banks try to target house prices.

“Should we buy that house? The price does seem rather high, compared to everything else. You don’t think it might be a bubble, like in the 2000’s?”

“No, it can’t be a bubble, because the central bank assured us its new monetary policy would prevent house price bubbles. And in any case, (the relative price of) everything else … seems to be falling … so the only safe investment seems to be in houses. If we don’t get into the housing market now, our savings will keep on depreciating, and we never will be able to afford to buy a house.”

Effectively, by saying that they will control asset prices (and being credible) they convince people that current house prices are at a fundamentally sound level. This does not prevent the existence of multiple equilibrium for house prices, and if anything it may help to drive house prices to other equilibrium by increasing the confidence that “this is not a bubble”.

  • interesting.I will think about it

  • Miguel Sanchez

    Sounds fine to me. Inflation is about the general level of prices; relative price changes are still allowed. The problem with the current approach is that we end up with asset prices rising a lot and goods prices rising a bit, and central banks telling us that inflation isn’t a problem because the latter – a relative price – is under control. But in this example you have asset prices rising and everything else falling, so it’s not general inflation.

  • “The problem with the current approach is that we end up with asset prices rising a lot and goods prices rising a bit, and central banks telling us that inflation isn’t a problem because the latter – a relative price – is under control”

    But CPI includes the consumption price of housing – it just doesn’t include the capital gain associated with housing as an asset. As a result, CPI does capture a “type” of general price level (I say type because the CPI gets driven around by relative price shocks all the time – which means it needs to be interpreted with caution).

  • Miguel Sanchez

    “But CPI includes the consumption price of housing” – does it? There’s no imputed rent for home ownership in the New Zealand CPI, as there is in the US.

    Just to be clear, I’m not a fan of targeting asset prices (with the emphasis on ‘targeting’) – they’re a relative price, and the central bank has no business trying to manipulate relative prices. But I think they do need to take asset prices into consideration, because the CPI, while convenient, is an incomplete measure of inflation. That way, we won’t have to put up with central banks telling is that double-digit money supply growth isn’t inflationary, just because it’s not showing up in goods prices.

  • Raf

    But when asset price inflation starts to drive the economy then we have a big problem.

    The CPI is clearly inadequate in this type of environment. In fact one could argue the construction of the CPI, as opposed to a Cost of Living Index, can lead policymakers to make flawed assumptions about the level of general inflation in the economy.

    A Cost Of Living Index which actually measured real household expenditure (mortgage/rent, energy, food and so on) would be more helpful.

    It’s worth looking at the data over the last 20 years on House Prices, M3 growth and the CPI.

    I have the data somewhere but from memory M3 + House prices are highly correlated at double digit rates whereas the CPI has averaged something like 2.5% pa.

    Parallel universes? Let’s face it the last 20 years of deregulated debt has given us a debt economy……nothing more, nothing less.

  • Miguel Sanchez

    “I have the data somewhere but from memory M3 + House prices are highly correlated at double digit rates whereas the CPI has averaged something like 2.5% pa.”

    Hardly surprising when the RBNZ responds to one and not the other?

  • Raf

    Miguel,

    Just noted your 16.13 comment. I guess we are in complete agreement!

    The CPI is a load of old cobblers.

  • John

    “Effectively, by saying that they will control asset prices (and being credible) they convince people that current house prices are at a fundamentally sound level.”

    but the main thing is what people see. Only a minority understand the economic theory.

    “And in any case, (the relative price of) everything else … seems to be falling … so the only safe investment seems to be in houses. If we don’t get into the housing market now, our savings will keep on depreciating, and we never will be able to afford to buy a house.””

    other person says:
    “and Britain’s overcrowded, Harcourts have an office in Shanghai and places like Australia and the US are magnets for migrants.. and there’s cities in China bigger than London that no one has ever heard of… (and the businessmen in NZ have a freehand on the migration spigot) so prices will keep going up.”

    Yet another
    “yeah John Banks says that Auckland will get a population increase equal to Wellington in the next 14 years!”.

  • John

    I don’t think the struggling people at the bottom see the piece of land they own or aspire to own the same way as the mobile upper layer.

  • Hi,

    I also feel that the problems lies in our approach for having increased assets pricing and it is indeed hooks up. The relative price ration for assets and goods is also significant. It needs to be settled down….targeting asset pricing is going to be an issue!

    – j.

  • Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money.

  • The CPI is clearly inadequate in this type of environment. In fact one could argue the construction of the CPI, as opposed to a Cost of Living Index, can lead policymakers to make flawed assumptions about the level of general inflation in the economy.

  • The relative price ration for assets and goods isn’t the big issue. One needs to measure real household expediture.