There is much agreement that asset prices, in particular residential property prices, provide a crucial link through which adverse macroeconomic developments can cause financial instability. Episodes of asset price booms are seen by many as raising the risk of a future sharp “correction” of prices, which could have immediate repercussions on the stability of financial institutions. Indeed, many observers have argued that property-price collapses have historically played an important role in episodes of financial instability at the level of individual financial institutions and the macro economy (e.g. Ahearne et al. 2005, Goodhart and Hofmann 2007).
Not surprisingly, this view has led to calls for central banks to react to movements in asset prices “over and beyond” what such changes imply for the path of aggregate demand and inflation (Borio and Lowe 2002, Cecchetti et al. 2000). Proponents of such a policy emphasise that episodes of financial instability risk depressing inflation and economic activity below their desired levels. Consequently, they argue, central banks that seek to stabilise the economy over a sufficiently long time horizon may need to react to current asset-price movements (Bean 2004, Ahearne et al. 2005). Importantly, this idea does not mean that asset prices should be targeted, only that central banks should be willing to tighten policy at the margin in order to slow down increases in asset prices that are viewed as being excessively rapid in order to reduce the likelihood of a future crash that could trigger financial instability and adverse macroeconomic outcomes.
While seemingly attractive, this proposed policy presumes that central banks are able to identify in real time whether asset prices are moving too fast or are out of line with fundamentals. Of course, it is by no means clear that they are better able to judge the appropriate level of asset prices and the risk of future sharp price declines than agents transacting in these markets. Furthermore, the policy has implications for the speed by, and the extent to which, monetary policy impacts on the economy (Bean 2004, Bernanke 2002, Kohn 2006). First, changes in policy-controlled interest rates must have stable and predictable effects on asset prices. Second, the effects of monetary policy on different asset prices, such as residential-property and equity prices, must be about as rapid, since stabilising one may otherwise lead to greater volatility of the other. Needless to say, if these criteria are not satisfied simultaneously, any attempts by central banks to offset asset-price movements may simply raise macroeconomic volatility, potentially increasing the risk of financial instability developing. Third, the size of interest-rate movements required to mitigate asset-price swings must not be so large as to cause economic activity and, in particular, inflation to deviate substantially from their desired levels since, if this were to be the case, the resulting macroeconomic cycles could lead the public to question the central bank’s commitment to price stability. Fourth, the effects of monetary policy on asset prices must be felt sufficiently rapidly so that a tightening of policy impacts on asset prices before any bubble would burst on its own (since policy should otherwise presumably be relaxed to offset the macro economic effects of the collapse of the bubble).
Unfortunately, however, it is unclear whether monetary policy has predictable effects on asset prices and, if so, whether these effects occur at about the same time horizons for different asset prices, whether they are large relative to the effects of monetary policy on inflation and economic activity, and whether they materialise faster than the effects on inflation and economic activity. While the “over and beyond” approach to monetary policy and asset prices is seemingly attractive, further work on the transmission mechanism of monetary policy and the role of asset prices is thus warranted.
This paper is part of that work and seeks to shed light on the impact of monetary policy on residential-property and equity prices, inflation and output growth. To do so, we establish empirical regularities, as captured by the impulse-response functions of vector autoregressive models (VARs), that theoretical models of the relationship between monetary policy and asset prices must account for. Instead of testing any specific hypothesis, we follow the research strategy of Goodhart and Hofmann (2008), which estimates VARs that uses minimal identifying assumption to study closely related issues. One attractive feature of both papers is that they look at a broad cross section of countries, which experienced asset price movements of varying severity and at varying points in time. This avoids the bias that comes from looking mainly at countries that have undergone particularly pronounced asset price cycles.
We also investigate the role of financial structure for the link between monetary policy and asset prices. A number of authors have argued that the strength of the transmission mechanism depends on institutional characteristics of the financial system. In particular, it has been argued that the reaction of output and inflation to monetary policy shocks is likely to be stronger in financial systems that are more “flexible” and market based. The existing literature has proposed a number of statistical measures – such as relative importance of fixed versus floating rate lending, or average loan to valuation ratios – to capture these characteristics. In studying the importance of the financial structure, we simply use various statistics reported in the literature.
To perform the analysis we study a panel of 17 OECD countries using quarterly data for the period 1986-2007. The analysis proceeds in three steps. Following Iacoviello (2002) and Giuliodori (2005), we first study the impact of monetary policy on the economy by fitting VARs for individual countries. Not surprisingly, the resulting estimates are imprecise, leaving considerable uncertainty about the quantitative effect of changes in interest rates on asset prices relative to their impact on economic activity and inflation, as would seem to be an important precondition for monetary policy to be used to mitigate asset-price movements. Moreover, it is difficult to know whether these differences are significant and whether they depend on the financial structure.
To raise the precision of the estimates, we thus follow Goodhart and Hofmann (2008) and estimate a panel VAR (PVAR) incorporating real residential-property and real equity prices. Our results show that while monetary policy does have important effects on asset prices, those effects are not particularly large relative to those it has on inflation and output. This suggests that attempts to stabilise asset prices by using interest rate policy are likely to induce pronounced macroeconomic fluctuations.
However, while the panel estimates confirm that monetary policy has predictable effects on residential-property prices, by construction these estimates disregard all country-specific information. In order to study the importance of institutional factors, we go on to split the sample of countries into two groups depending on their financial structure. We then estimate a panel VAR for each group and explore whether the impact of monetary policy on asset prices, inflation and output differs between the two groups. We use several measures proposed in the literature to capture differences in financial structure, including the importance of floating rate lending; whether mortgage equity withdrawal is possible; the loan-to-value ratio for new mortgages; the mortgage-debt-to-GDP ratio in the economy; the method used to value property; whether mortgages are securitised; and the share of owner occupied dwellings. Since the notion of a financial system is a multi-faceted concept and these measures each only capture one aspect, it is possible that they lead to an underestimate of the importance of institutional factors. We therefore end the study by using the mortgage market index recently proposed by the IMF (2008) to capture the joint impact of financial market characteristics on the monetary transmission mechanism. To preview briefly the results, we find that the financial structure does condition the responses of asset prices to monetary policy but also that the differences between country groups are less important than perhaps commonly thought.
The paper is organised as follows. The next section contains a discussion of the data and Section 3 presents the results for the VARs estimated for individual countries. In Section 4 we first briefly discuss panel VARs before discussing the estimates. Section 5 focuses on the importance of financial structure and provides panel-VAR estimates when the countries are divided into two groups on the basis of financial structure. Finally, Section 6 concludes.
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